How to Spot Financial Trouble at Companies


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Simple, easy-to-understand steps outlining how to make sense of a company's financial statements.

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  • Leonard Dennis Kozlowski[1] (born November 16, 1946) is a former CEO of Tyco International, convicted in 2005 of crimes related to his receipt of $81 million in purportedly unauthorized bonuses, the purchase of art for $14.725 million and the payment by Tyco of a $20 million investment banking fee to Frank Walsh, a former Tyco director. He is currently serving 8.33 to 25 years at the Mid-State Correctional Facility in Marcy, New York. His earliest release date is January 17, 2014, when he becomes eligible for parole
  • In 2005, he was convicted of fraud and conspiracy as a result of WorldCom's false financial reporting, and subsequent loss of US$100-billion to investors. The WorldCom scandal was, until the Madoff schemes came to light in 2008, the largest accounting scandal in United States history. He is currently serving a 25-year prison term at Oakdale Federal Correctional Complex in Louisiana.
  • Houston energy company failed in 2001. Symbol of corporate greed and corruption .Bogus accounting. Created fake blackouts and shortages so company could raise electricity prices and book huge profits. Enron ruined Arthur Andersen, one of the nation’s top accounting firms.
  • In March 2009, Madoff pleaded guilty to 11 federal felonies and admitted to turning his wealth management business into a massive Ponzi scheme that defrauded thousands of investors of billions of dollars.
  • How to Spot Financial Trouble at Companies

    1. 1. Funny Money How companies play games with numbers By Mark Tatge DePauw University
    2. 2. Author, TV guest, professor
    3. 3. Ex-Tyco CEO Dennis Kozlowski Guilty: Misappropriation of funds. Cost: $81 million Misbehaving CEOs
    4. 4. Guilty: Fraud and conspiracy. Cost: $100 Billion Ex-Worldcom CEO Bernie Ebbers
    5. 5. Guilty: Securities Fraud. Cost: $11 billion Kenneth Lay Enron • Faked blackouts and shortages so company could raise electricity prices and book huge profits. • Duped investors with shell games, phony financials. • Enron failed 2001. • Died 2006, heart attack.
    6. 6. Guilty: Fraud. Cost: $60 billion. Bernie Madoff
    7. 7. Aggressive accounting is rewarded. Higher numbers = higher stock price. Bigger piece of CEOs compensation tied to stock. Accountants hired and paid by the company. • Firm provides the numbers. • Most companies are honest. • But fraud has been on the rise. • • • • Why fraud occurs
    8. 8. WHERE TO LOOK
    9. 9. • If a company is going to deliberately falsify a financial statement – it will be very difficult to find. • Deal with what is publicly disclosed – not what we can’t access. The Coverup
    10. 10. • Are the statements you are viewing audited? • Are the statements prepared in accordance with Generally Accepted Accounting Principles (GAAP). • Are they based on cash or accrual? • Are you viewing more than one period’s data? Concept: Basic rules
    11. 11. Concept: Cash v. Accrual
    12. 12. • Companies are supposed to match each revenue item with its corresponding expense. Concept: Matching Principle
    13. 13. • Recording fake or bogus revenue • Boosting income on one-time gains (asset sales). • Recording revenue too soon, or revenue of questionable quality. • Release of excess reserves – to cover losses. Watch for revenue games
    14. 14. • Companies also play games with expenses – but if there is going to be a problem it will most likely be on the revenue side of the equation. Revenue matters
    15. 15. • Companies are supposed to match income with the corresponding expense. • The period where the revenue is recorded, the expense used to create that revenue should be expensed. • But some companies will defer expenses until a later period of time. Tip 1: Deferring expenses
    16. 16. • AOL in 1994 decided to exclude current marketing costs in its profit. • Instead of immediately expensing these costs – AOL shifted them to the balance sheet as an asset and charged them off in future periods. • This decision had the impact of inflating AOL’s profits since it did not expense market costs. • These costs were amortized over time. Lesson: marketing costs
    17. 17. • Companies that plan to merge or divest often will come up with “pro-forma” earnings. • Pro-forma is supposed to be an estimate of what the firm will be after the merger. • Often based on inaccurate assumptions. • Management will include or remove net income that it feels is not “material” to the remaining operations of the company. Tip 2: Pro-forma earnings
    18. 18. • Has the company recently changed accountants? • The change may have occurred due to a disagreement over accounting standards. Tip 3: Firing auditors
    19. 19. • Companies often bury important documents and then reference them in reports. • Finding the detail means looking through several levels of reports dating back quarters, or in some cases, years. • 8Ks are a catchall – may be changes in CEO compensation agreement, changes in accounting policies, even changes in auditors. Tip 4: Burying Exhibits
    20. 20. • How a company accounts for the value of its inventory can have a big impact on profits Tip 5 – Fudging Inventory
    21. 21. • Inventory are goods that are finished and available for sale. May also be “raw materials” used in finished goods. • The company must actually sell these goods to produce cash. Concept: Inventory
    22. 22. • The value of a company’s inventory is found on the balance sheet, categorized as an asset. Concept: Inventory
    23. 23. • Executives faked inventory to borrow millions. • Told the lenders the money was for expansion. • Pharmor needed the cash to pay suppliers. • Pharmor was forced to file bankruptcy. • Founder and CFO sent to prison. Lesson: Pharmor (1992)
    24. 24. • Companies are expected to use a single standard in measuring the value of inventories. • •    FIFO – First in- First Out LIFO – Last in – First Out. LIFO - charges the latest (or last inventory) costs first FIFO – charges the earliest (or oldest) costs Companies are required to pick one method and are not allowed to keep switching back and forth Concept: Inventory
    25. 25. • In times of rising costs, the differences can be substantial. If a company switched to FIFO – this would produce much higher profits. Concept: Inventory
    26. 26. • Beware of stock buybacks. • Flashes sign company is confident in its future prospects. • Should the company be doing something different with its cash? • Buyback artificially improves earnings per share. Tip 6: Stock buybacks
    27. 27. • • • • EPS = Net earnings / Outstanding shares. $10 million / 5 million shares = $2.00 EPS After 3 million share buyback $10 million / 2 million shares = $5.00 EPS Concept: Boosting EPS
    28. 28. • Companies are forced to set aside funds to cover defaults, decreases in asset values, inventory obsolescence. • The asset reserve or pot of money set aside is expensed and reduces net income. Tip 7: Shell games
    29. 29. • As assets are written down, the amount of the written down is charged against the reserves. • If a company has set aside too much – it can recapture reserves. • Failing to reserve enough to cover potential losses boosts profits – firm’s expenses are less. • Recapturing extra funds set aside in reserves – can also artificially boost profits for a given quarter. Shell games to watch
    30. 30. • • • • Cash flow – is often more important to earnings. How much cash flow is the company generating? How much cash is the company burning? Does the company have enough cash to cover its current liabilities. Tip 8: Pay attention to cash
    31. 31. What are the sources and uses of cash?
    32. 32. Lesson: Cash flow
    33. 33. • Subtract current liabilities from current assets. The calculation tells us how much in liquid assets the company has on had to pay its debts during the next year. Lesson: Cash Flow
    34. 34. • As you can see using the figures from Dell's abbreviated balance sheet, we have approximately $1.48 of current assets to cover every dollar of liabilities. This is OK, but nothing superior. A better margin of comfort would be a 2-to-1 ratio. Lesson: Cash flow
    35. 35. • Companies understate liabilities. This inflates current earnings • Best example of this is pension and retiree health care obligations. • Has the company signed contracts or agreed to contingencies that could cost it dearly? • Merger breakup fees • Legal obligations / pending lawsuits • Contractual arrangements with vendors. Tip 9: Understating Liabilities
    36. 36. • GM and many cities and states have grossly underfunded their their pensions Lesson: GM Pension Mess
    37. 37. • Watch filing deadlines. • If a company misses or delays filing a 10Q or 10K – it usually means something is wrong. Company may be faced with: • • • • Bankruptcy or liquidation. Face a large charge against earnings. Re-valuation of assets or the business. Restatement of past financial results. Tip 10: Blowing deadlines
    38. 38. • No one item on this list is a silver bullet. • Uncovering problems often involves being a careful reader of financial statements and drawing comparisons. • If you don’t understand then ask. (e.g. Enron) • If the company can’t explain it – you probably have a story. • It if looks too good to be true – it probably is. A few parting thoughts…