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Financial Statement Analysis


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Table of Contents

Preface to Fourth Edition xi Acknowledgments xv Part One Reading between the Lines Chapter 1 The Adversarial Nature of Financial Reporting 3 The Purpose of Financial Reporting 4 The Flaws in the Reasoning 8 Small Profits and Big Baths 11 Maximizing Growth Expectations 12 Downplaying Contingencies 18 The Importance of Being Skeptical 20 Conclusion 24 Part Two The Basic Financial Statements Chapter 2 The Balance Sheet 29 The Value Problem 30 Comparability Problems in the Valuation of Financial Assets 32 Instantaneous Wipeout of Value 34 How Good is Goodwill? 35 Losing Value the Old-Fashioned Way 38 True Equity is Elusive 40 Pros and Cons of a Market-Based Equity Figure 41 The Common Form Balance Sheet 43 Conclusion 45 Chapter 3 The Income Statement 47 Making the Numbers Talk 47 How Real Are the Numbers? 52 Conclusion 77 Chapter 4 The Statement of Cash Flows 79 The Cash Flow Statement and the Leveraged Buyout 81 Analytical Applications 86 Cash Flow and the Company Life Cycle 87 The Concept of Financial Flexibility 99 In Defense of Slack 104 Conclusion 106 Part Three A Closer Look at Profits Chapter 5 What is Profit? 111 Bona Fide Profits versus Accounting Profits 111 What is Revenue? 112 Which Costs Count? 114 How Far Can the Concept Be Stretched? 116 Conclusion 117 Chapter 6 Revenue Recognition 119 Channel-Stuffing in the Drug Business 119 A Second Take on Earnings 123 Astray on Layaway 127 Recognizing Membership Fees 128 A Potpourri of Liberal Revenue Recognition Techniques 131 Fattening Earnings with Empty Calories 132 Tardy Disclosure at Halliburton 138 Managing Earnings with Rainy Day Reserves 141 Fudging the Numbers: A Systematic Problem 143 Conclusion 147 Chapter 7 Expense Recognition 149 Nortel's Deferred Profit Plan 149 Grasping for Earnings at General Motors 154 Time-Shifting at Freddie Mac 157 Conclusion 159 Chapter 8 The Applications and Limitations of EBITDA 161 EBIT, EBITDA, and Total Enterprise Value 162 The Role of EBITDA in Credit Analysis 166 Abusing EBITDA 169 A More Comprehensive Cash Flow Measure 171 Working Capital Adds Punch to Cash Flow Analysis 174 Conclusion 176 Chapter 9 The Reliability of Disclosure and Audits 179 An Artful Deal 180 Death Duties 183 Systematic Problems in Auditing 184 Conclusion 189 Chapter 10 Mergers-and-Acquisitions Accounting 191 Maximizing Postacquisition Reported Earnings 191 Managing Acquisition Dates and Avoiding Restatements 195 Conclusion 197 Chapter 11 Is Fraud Detectable? 199 Telltale Signs of Manipulation 199 Fraudsters Know Few Limits 201 Enron: A Media Sensation 201 HealthSouth's Excruciating Ordeal 210 Milk and Other Liquid Assets 217 Conclusion 221 Part Four Forecasts and Security Analysis Chapter 12 Forecasting Financial Statements 225 A Typical One-Year Projection 225 Sensitivity Analysis with Projected Financial Statements 237 Projecting Financial Flexibility 242 Pro Forma Financial Statements 245 Pro Forma Statements for Acquisitions 246 Multiyear Projections 253 Conclusion 263 Chapter 13 Credit Analysis 265 Balance Sheet Ratios 266 Income Statement Ratios 275 Statement of Cash Flows Ratios 280 Combination Ratios 283 Relating Ratios to Credit Risk 290 Conclusion 304 Chapter 14 Equity Analysis 307 The Dividend Discount Model 308 The Price-Earnings Ratio 313 Why P/E Multiples Vary 316 The Du Pont Formula 324 Valuation through Restructuring Potential 328 Conclusion 334 Appendix Explanation of Pro Forma Adjustments for Hertz Global Holdings, Inc./DTG 335 Notes 341 Glossary 353 Bibliography 367 About the Authors 369 Index 371

About the Author

MARTIN FRIDSON is Global Credit Strategist at BNP ParibasInvestment Partners, one of the world's largest asset managers.Over a twenty-five-year span with brokerage firms including SalomonBrothers, Morgan Stanley, and Merrill Lynch, he became known forhis innovative work in credit analysis and investment strategy.Fridson has served as president of the Fixed Income AnalystsSociety, governor of the Association for Investment Management andResearch (now CFA Institute), and director of the New York Societyof Security Analysts. FERNANDO ALVAREZ is currently an Adjunct AssociateProfessor of Finance and Economics at the Columbia UniversityGraduate Business School, where he teaches entrepreneurshipfinance. From 2003 until 2008, he was associate professor in theFinance and Economics Department and director of entrepreneurshipprograms at Rutgers Business School, Newark and New Brunswick.Alvarez has taught at New York University's Stern School ofBusiness where he was associate professor on innovation andentrepreneurship, and Babson College where he was assistantprofessor of finance.


"Financial Statement Analysis: A Practitioner's Guide is a well-organized, thorough exploration of the challenges facing practitioners who rely on financial statements to make investment and lending decisions. Reference books about accounting, while valuable for their insights, are seldom this enjoyable to read. This book is different because the authors seamlessly integrate fascinating real-life examples and instructive fictional scenarios into each chapter to illustrate their points. For anyone with a passing interest in the subject, or for new analysts learning the trade, Financial Statement Analysis is an amazing resource." ?Christopher Shayne, CFA, Director of Product Operations for Enterprise Risk Solutions at Moody's Analytics "Any book that reaches its 4th edition (updated to 2011) should be good. That's true in spades for Financial Statement Analysis. Fridson and Alvarez have written a classic. It should be required reading and a constant reference source on the bookshelf of any investor intending to buy individual company stocks or bonds." ?Canadian Financial DIY blog "In the 1990s, Benjamin Graham's Security Analysis served as [Value Partners?] reference book, but since then they have been using Martin Fridson's Financial Statement Analysis: A Practioner's Guide." ?excerpt from The Value Investors: Lessons from the World's Top Fund Managers by Ronald Chan, Bruce C. N. Greenwald (Foreword)

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