Look Beyond Companies' Glossy Reports

Physician's Money Digest, June15 2003, Volume 10, Issue 11

Companies often step upefforts at year-end to presenttheir investors with a favorableannual report. A new study byLondon-based REL ConsultancyGroup reveals that many companiesengage in an annual accounting ritual,which aims to improve the appearanceof corporate balance sheets.

A lift here and a tuck there can dowonders for the books. Corporateexecutives and accountants generallydo this financial maneuvering withinlegal and ethical boundaries. Still,physician-investors should be awareof these annual accounting faceliftsand be able to discern the differencebetween fact and fiction.

Wall Street Journal

A report notesthat balance-sheet polishing techniquesare being researched by REL,a consulting firm that helps companiesmanage their working capital (ie,the cash a company uses to financethe conversion of raw materials intofinished goods, then to sell thosegoods and collect the money owed it).

The faster a company can sell itsfinished goods, the faster it can purchasenew raw materials to again convertinto finished goods. Elements ofa company's working capital includelevels of inventory, accounts receivable,and accounts payable. Workingcapital is considered by analysts to bea good indicator of a company's efficiency and financial strength.

REL recently focused its researchon the 1000 largest US companies.The firm examined the balancesheets of these companies at the endof 2001 and again 3 months later.REL found that some companies goto great lengths to make themselveslook better, by such means as reducinginventory levels and accountsreceivable. The 1000 companies wereable to reduce their inventories by atotal of $70 billion, or 12%, from theprior quarter by shipping out more oftheir products at year's end.

This is where investigating can payoff for physician-investors. Did customersreally want that entire inventory?The study revealed that inventoriesretraced their path 3 months later, rising$70 billion. This indicates thateither the customers returned some ofthe inventory, or they cut back ontheir purchases in the new yearbecause they were overstocked.

QUARTERLY COMPARISONS

Researchers also found thatcompanies pushed to get customersto pay their bills by the end of theyear in order to free up cash for newraw material purchases. Accountsreceivable fell $20 billion, or 2%, inthe fourth quarter, but rose $60 billion,or 5%, in the first quarter.Accounts payable also fell significantly in the fourth quarter, only torise again in the first quarter.

Mark Tennant, a senior VP atREL, says the net result is that workingcapital fell $45 billion, or 4%, inthe fourth quarter, thus making companieslook more efficient. In the firstquarter, however, the trend reverseditself when net working capital rose$55 billion, or 5%. Net debt alsoexperienced a decline at the end ofthe fourth quarter, followed by anincrease in the first quarter.

Should you be concerned aboutsuch swings across many industries?That depends. Retailers that typicallyhave increased sales activity duringthe Christmas season would beexpected to have lower inventory atthe end of the year, the article notes.But in other industries, steep year-endreductions in accounts receivable cansignal big changes for the company.

You can find out why the balancesheet numbers have changedby looking in the management's discussion-and-analysis section of theannual reports that companies filewith the SEC. The commitmentsand contingencies footnotes are alsoa good place to look.

GOOD AND BAD INDICATORS

Selling receivables might indicatethat a company is experiencing a cashcrunch, or that the company's customersare having trouble payingtheir bills. The article notes that whilerising inventories could mean futureproblems, it could also be a sign thatbusiness is prospering. Look in thefootnotes to the company's financialstatements. Here you will find importantinformation about what's in thecompany's warehouses.

The article notes that if finishedgoods are piling up and raw materialsare down, it's a sign that the companyis having trouble selling its product.On the other hand, if raw materialsare up and finished goods are down,it could mean business is good andmanagement is stockpiling inventoryin anticipation of rising sales.

With some diligence, physician-investorscan identify certain trendsin inventory, accounts receivable, andaccounts payable. Look beyond thoseseemingly rosy annual reports, andyou're likely to get a more accuratepicture of a company's financialstanding.

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Annual Report File

For access to a company's annualreports, physician-investors can visitthe SEC's electronic filing system,called the Edgar database. It's chock-fullof facts on company filings,including quarterly and annual reports.These documents should bethe first stop for investors—they spellout the fiscal results for the year aswell as management views on thechallenges facing a company in thefuture. The annual reports also listthe status of any current litigationagainst a company as well as othervital information for investors. For apeek into Edgar's filing cabinet, logon to www.sec.gov/edgar.shtml.