I’m sitting here in my mid-town office listening to the sounds of drums beating and whistles blowing. The noise is being made by a rather large group of protesters against Enron. This is the first time I actually agree with the protesters. Everyone should be protesting this 21st century corporate debacle.
While Enron is receiving the lion’s share of the press (and protests), there are several other recent corporate failures that should be looked at with a magnifying glass as well. Of the 18 largest US bankruptcies since 1981, seven occurred between 2001 and 2002 for a combined total asset base of $164 billion! Forgetting about the Internet bubble and bust, these are real companies; Enron, K-Mart, Global Crossing, Pacific Gas and Electric and Finova to name a few. What can we learn from these latest tragedies?
Center stage in the press is the issue of transparent and clear financial reporting. As a young analyst I always thought that the public companies were the easiest to analyze due to the vast amount of documents available. Glossy annual reports, analyst reports, 10K’s, 10Q’s, etc. The hard ones to analyze were the privately held companies that may or may not have an auditors’ clean opinion attached to the financial statements. In those cases, the analyst had to dig, dig and dig some more. Maybe that is what we need to do again.
My first accounting professor reminded the class that 2 plus 2 is anything you want it to be in accounting. Not to berate my brethren in the accounting profession, but this has been going on for a very long time. Analysis has always been getting behind and beyond the numbers.
It is so easy to analyze a company when sales, margins and cash-flow are increasing year after year. This is what happened in the lofty 90’s when basic analysis went out the window. As long as the company’s stock price was going up, they could use their shares as currency to buy other companies or pledge their shares as collateral. Who cared about meeting with management and gaining that “gut feel” that debt and equity providers get. Enron anyone? Who cared about looking at the board of directors?
Below are my 10 basic rules for analysis – whether it is for debt or equity providers.
- Meet the highest level of management you can. What is their strategy? Does it make sense? If it’s a small private company, meet with the owner as he/she will usually be the CEO, COO and CFO (not a good sign). Entrepreneurs love to talk about their companies and if given the chance will chew your ear right off. A wealth of information can be gleaned in such a meeting. If you are analyzing a Fortune 500, chances are you won’t have the opportunity to meet the key decision makers. Even if you meet with the assistant treasurer, you can still obtain a wealth of information if you ask the right questions.
- Look at the board: Are they: Competent. What is their field of expertise? Do they have related business experience or are they there for window dressing? One company I met had a very famous baseball player on the board. While it was a thrill for me to meet him, he didn’t have a clue about finance and was sitting on the finance and audit committees! 2) Commitment. What is their obligation to the company? Is this just one of 15 boards the member is on? 3) Compensation. How is the board paid? In cash, shares or both? If it’s only equity, will their judgment be clouded?
- Do your homework! Before meeting with the company, read the annual report including the Chairman’s statement. Read between the lines. Also, read those very boring footnotes. This is where the detective work really pays off. There are jewels of information tucked away in the footnotes that the accountants and company would rather you really didn’t read but are required to put the information somewhere to comply with GAAP.
- Be wary of lofty financial terms. Proforma, core earnings, economic earnings, special one-time charges. Companies can have substantial latitude in the use of these terms. Read the footnotes! Are those one-time charges really one-time? If you are unsure, add back the charges to see what the “real” earnings would have been.
- Analyze the cash flows. To stress a point – Profits do not pay a single creditor back. Cash does. EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) has become a household term on Wall Street. While it is one measure of earnings, it is not the only one to look at. A quote from the Berkshire Hathaway Inc. 2000 annual report says it all: “References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?”
- If looking at the long-term, create a set of meaningful projections. Management is always optimistic about the future of their business. Temper the key variables to show what could happen in a real worst-case scenario a.k.a. the nuclear winter case. Unfortunately, many times the worst-case scenario becomes the actual case going forward.
- Watch the company’s share price. While a high share price can give you some comfort, the stock market can be brutal and send the share price to depressing levels within a day. A low share price can be very indicative of bad news.
- Kick the tires. Take a tour of the plant. Do the workers seem happy? Is the plant clean? What is the safety record? If you don’t have the opportunity to visit the plant, what is the office environment like? You can glean a lot from the office ambience. How does this reflect upon management?
- Review the industry and the company’s competitive position. How does your company stack up against the competition in terms of gross margins, turnover ratios, return on equity, etc. If they are clearly ahead of the competition, they are either doing a terrific job, or they may be hiding something.
- Stay on top of your company. Don’t file away all your fabulous research and never look at it again. While sometimes a menial chore, the figures should be updated at least quarterly (if you have access). This is a good time to ask questions, especially when the ratios start to move in the wrong direction.
Remember the basics. Dig, dig, and dig. Ask a lot of questions. Tough questions. You won’t always get it right, but I bet you’ll be more right than wrong.
Julie Barnum is teaching the following courses this Fall:
Early Warning Signs
Financial Forecasting
