Read the Bottom Line Between the Lines

September 16, 2008
Ed Rabinowitz

Physician's Money Digest, March15 2003, Volume 10, Issue 5

First Enron, then WorldCom.What other surprises mightbe lurking around the cornerfor physician-investors? Thetruth is, we don't know. And in thiscase, ignorance is not bliss. Arecent study by Bloomberg Newsfound that of the 673 largest publicbankruptcies since 1996, 54% ofcompany auditors provided no cautionsin their financial statementsin the months preceding the company'sbankruptcy.

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It's disheartening news for anyphysician-investor, but an overduewake-up call that needs to beanswered. Nowadays, understandingthe ways companies manipulatefinancial reports is as important asunderstanding the market. Luckily,a recent report highlighted some of the keythings to look for when browsingcompany financial news. The followingis a list of what you shouldlook for when you read:

• Embellishment of revenueline. There are a number of tacticscompanies use to make it seem asthough revenues are rising. One wayis to extend significant amounts ofcredit to financially strapped customersand to unload products ontodistributors. Companies then recordthis as revenue received, even thoughthey have not yet received payment.Sometimes the amount owed is indispute and may never be collected.This figure can be tracked using thereceivables turnover ratio in a company'sfinancial statements.

• Growing profits. Some companiesmanipulate profits by usingpro forma numbers, an accountingtrick that allows it to include (orexclude) almost anything it wants.Companies also tend to be overlyoptimistic when forecasting thegrowth of their pension plan assets.That's because the greater theassumptions, the smaller the hit toprofits from pension costs. To determinethe quality of a company'searnings, examine the cost side ofits income statement. A red flag iswhen a company's net income is rising,but free cash flow (ie, theamount remaining after paying thebills) is falling.

• Rising cash flow. This claimby companies may be perfectlyaccurate, but there are other factorsto examine as well. For example, areaccounts payable growing? Thiscould signal that the company owesa great deal and is simply not payingits bills. In addition, companies arerequired to record tax benefits fromthe exercise of employee stockoptions as part of operating cashflow. When tax breaks boost reportedcash flow, they mask a company'sperformance and ability to generatecash. Also, cash flow often paints anincomplete picture when figures areincluded from operations that revealnothing of the company's trueearnings capability.

• Heavy buying sprees. At firstglance, a potential investor mightsay, "With all the businesses thiscompany is acquiring, it must trulybe growth-oriented." However, firstglances can be misleading. Whatmergers do, more often than not, iscomplicate a company's financialstatements. As a precaution, checkthe changes in goodwill, or intangibleassets, on a balance sheet, aswell as the sources of that goodwill,following a merger. If there are substantialcharges, such as the write-downof inventory or "in-process"research and development, it couldbe a red flag.

• Indecipherable boasting. Abig clue that something was wrongat Enron was the complexity of itsstatements, caused by a large numberof operating subsidiaries andpartnerships. The more businessesa company has, the more effectivelyit must manage, and the moredifficult and complex it is forinvestors to comprehend the company'sfinancial statements. If thereare significant footnotes to a company'sfinancial statements, especiallythose related to reporting forsubsidiaries and other businessunits, it's best to proceed with caution.