Friday, April 9, 2010

Stock versus Flow: My thoughts

When analyzing companies, the three financial statements that we primarily use are the income statement, the balance sheet and the statement of cash flows. We obtain the inputs for earnings and cash flows from the income and cash flow statements and the numbers for debt, cash and working capital from the balance sheet.

While all three statements are governed by accounting standards and are audited, there is a key difference between them. Income and cash flow statements represent flow statements: they measure how much the company earned and spent over the period. Balance sheets capture the values of assets and liabilities at a point in time and thus represent "stock" statements.

So what? Stock statements are inherently less trustworthy than flow statements, because the numbers may not be representative of what the company did over the course of the year. This can be manifested in almost every number extracted from a balance sheet:

a. Debt: The debt that is reported on December 31 of a fiscal year will reflect what was owed on that day. A company can therefore pay down debt on December 30 and borrow again early the next year, manipulating its debt figures. In fact, there is a story in the Wall Street Journal about banks doing exactly this to make themselves look less indebted and thus safer.
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html 
Another common way in which debt can be kept off the books is by using lines of credit or seasonal financing during the course of the year but to pay them down by the end of the year.

There a couple of clues that we can use to detect this practice. One is to look at quarterly balance sheets, in additional to the year-end balance sheet, with the intent of finding big changes in debt from quarter to quarter. While enterprising companies may still be able to hide debt, it is much more difficult to do so on a quarterly basis. The other is to look at interest expenses as a percentage of the year-end debt. If a firm has debt for the bulk of the year, it has to pay interest expenses on that debt, even if it retires the debt towards the end of the year. As a result, the book interest rate (interest expense/ book debt) will be disproportionately high (relative to what you would expect the company to pay.

b. Cash: The cash on a balance enters intrinsic valuations as an add-on to the estimated value of the operating assets and relative valuations when we use enterprise value multiples (where cash is netted out of debt). However, the cash balance on the balance sheet may bear little or no resemblance to the actual cash balance today (which is really the number we should be using in intrinsic and relative valuation). This is one reason why some firms actually trade at negative enterprise values, where market equity is updated to reflected today's value but debt and cash remain frozen at year-end values.

c. Working capital: Net working capital is the difference between non-cash current assets (inventory and receivables) and non-debt current liabilities (payables and other accrued liabilities). Any of these numbers can be altered over short periods. For instance, receivable collections can be stepped up and inventory cleared (how about those year end clearance sales) just before balance sheet dates to make working capital look smaller.

In closing, I am not suggesting dynamic balance sheets. That would be too expensive and not quite practical. However, I am suggesting that we be more careful about balance sheet based analysis. Never trust a single balance sheet; if you can get quarterly balance sheets, do so; if you have access to the current numbers (on cash, debt and working capital), even better. The last may seem unrealistic but if you are the acquirer in a friendly merger, you should be able to demand and get this information from the target company.

5 comments:

Ramon Prat said...

I would also add to your comment the effect of accruals in both the income statement and the balance sheet. These two financial statements are very useful for valuation purposes because among the financial statements are the ones that provide the more punctual picture of the economic live of the company. On the other hand the statement of cash flows sacrifies punctuality (as only recognizes cash transactions) in exchange of reliability, it does so by removing the effects of accrual accounting. And analogy of the unique quality for the cash flow statement would be "it's better a bird in hand than two in the bush...".

Lumino de plume said...

Prof's notes could'nt have come at a better time, which is witnessing a plethora of voluntary transparency measures aimed at restoring the credibility of reported numbers and the books in itself, post the "colossal failure of common sense" in the past couple of years.

The importance of financial ratios that link a component of the P/L account to the relevant line item on the Balance Sheet cannot be over-emphasized. A further refinement would entail the study of such ratios between a Cash P/L and the Balance Sheet as against ideal efficiency standards

Shivagurunathan

valur_fannar said...

This could be a part of the answer why firms are often considered overvalued in general.

Unknown said...

I agree with Ramon the information if a company was able to generate cash flow during a period is useful but it can be manipulated easily by stopping payments to suppliers at the end of a period.

Another problem: A production company starts to build up stock during spring for sales during peak season in summer. Its customers have long payment terms so it collects the payments during fall. Depending on the end of period date your cash flow statement will show a different picture. Which is the right one?

stellabrownxyz said...

Heya..thanks for the post and great tips..even I also think that hard work is the most important aspect of getting success.
Acai Berry Diet
Acai Berry
Acai Max Cleanse
Diet Solution Program Review
How To Get Pregnant