Balance Sheet Analysis
Alexander Motola, CFA
Alexander Motola, 2013
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Quality of Earnings, Chapter 8
Two Key Ratios: Accounts
Receivable and Inventories
“…the best method I have ever discovered
to predict future downwards earnings
revisions by Wall Street security analysts –
is a careful analysis of accounts receivable
and inventories.” (QoE, pg. 107)
 Was is predicting future downwards
earnings revisions important?
 Is A/R and inventory analysis difficult?
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Quality of Earnings, Ch. 8

All of the examples are 30 years old – are
they still relevant today?
◦ Those business are (largely) gone
◦ Mgmt and investor psychology remain
◦ Accounting standards have evolved, but not
too much
◦ 2000-2002 market “event” was a repeat of the
1984-1985 debaucle
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Quality of Earnings, Ch. 8

In most financial analysis, we are less
concerned with the absolute (actual)
numbers, and more concern with the
change in the pattern
◦ You need a lot of data
 Many periods of numbers
 Competitor/Industry data where applicable
◦ You need to understand what the numbers
mean, and how they might be derived
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Accounts Receivable
Companies sell goods to customers – this
is revenue
 Customers either pay cash or use credit
(usually 30 days)
 If the customers don’t pay at the time of
the transaction (revenue), then A/R is
created
 Credit is a normal part of business; it
removes a transactional barrier
 What can we learn from credit?

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Accounts Receivable
Think about your job – what does your company
do? How soon do customers pay?
 There is normally an “appropriate” amount of
credit, relative to sales, for most businesses
 Calculations

◦ EOP (easiest): AR/Rev*#days
◦ AVE: [(Current period AR + Last Period
AR)/2]/Rev*#ofdays (91.25)
◦ 4Q Average: (5 AR [ave])/cumulative sales * #days
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Accounts Receivable

What A/R is on the balance sheet?
◦
◦
◦
◦
◦
What does “Net” mean?
What does “Gross” mean?
What is ADA?
Which # makes more sense, Net or Gross?
If Wall Street focuses on Net A/R, what does
that mean?
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Accounts Receivable

What is a “DSO”?
◦ It is an average
◦ It approximates the number of days – on
average – that it takes a company to turn a
sale (revenue) into cash
◦ Lower is better, but it depends on the
business cycle
◦ The faster you grow, the more working capital
you need…
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Accounts Receivable

I like Gross
◦ It *IS* the amount of money owed the
company
◦ The reserve does matter, it is estimated by
the company based on their “experience”
 If the reserve changes a lot, either the company is
manipulating earnings, A/R, or their “experience”
has changed – any one of these are important
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Accounts Receivable

Allowance for Doubtful Accounts

Look at the trend
◦ It’s not seasonal
◦ It probably impacted A/R, DSO, and EPS
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Accounts Receivable

Example of ADA T-Account
◦ You can see the income statement impact
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Accounts Receivable

DSO trend - ramps suddenly

Why are DSOs up?
◦ Economy weakening
◦ Regulatory changes
◦ More credit extension – financing customers, channel
stuffing, stealing from future revenues
◦ Customers can’t/won’t pay
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Accounts Receivable
Some companies will disclose their “Aging” in a
footnote
 Aging is more detail of the total A/R by different
buckets based on how long “past due” or current
they are
 Sometimes just a few customers skew the DSO
upwards because they can’t or won’t pay
 Companies HAVE to disclose if they have 1 or
more customers that make up 10%+ of sales or
A/R in any reported period

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Accounts Receivable
The dirty little secret – Factoring
Ramping DSO is seen as a collection
issue, analysts understand earnings quality
declines as DSO goes up
 Companies can sell A/R to finance
companies for X cents on the dollar


◦
◦
◦
◦
A/R down
Cash up
No tell tale on the SCF, either
It’s no economic for most companies, it’s
purely cosmetic, and comes at a cost
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Accounts Receivable

Is there a way to discover if a company is
factoring?
◦ Not really
◦ Most companies will tell you if you ask
◦ You can delve into their banking relationships, but you
aren’t likely to get very far

If you want to learn more, a good next step is to
read either
◦ What’s Behind the Numbers? Del Vecchio and Jacobs
◦ Financial Shenanigans – Schilit
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Inventory
This reflects the value add created by the
company on the balance sheet at the
product level
 It is a direct input into COGS
 Should a company have a lot of inventory?
 What questions should we ask about a
company’s inventory?

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Inventory
Like A/R, we can look at the absolute level
as well as the amount of inventory
relative to sales
 “Relative to sales” means DIO

◦ Days of Inventory Outstanding
◦ Is it really relative to Sales/Revenues?
◦ Basic calculation is: Inv/COGS*#days
 Why?
◦ What does DIO tell us as analysts?
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Inventory

Most companies report 3 “buckets” of
inventory
◦
◦
◦
◦
Raw Materials
WIP (Work in Progress)
Finished Goods
It obviously depends on the business model
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Inventory

Here’s an example of a footnote
◦ All three categories are there
◦ They also have the LIFO/FIFO adj
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Inventory
What does a lot of Finished Goods tell us
(as a mix of inventory)?
 What does a lot of Raw Materials tell us?
 These are both examples which would
cause Inventory $ and DIOs to go up, but
the conclusions are different…

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Inventory


DIO example
ONNN has a long history of DIO around 80
days

But then there’s this move of +40 days
◦ Big acquisition (SANYO)
◦ Not really worrying if they can “work it down”
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Inventory
DIO example
 ONNN has a long history of DIO around 80 days


But then there’s this move of +40 days
◦ Big acquisition (SANYO)
◦ Not really worrying if they can “work it down” – which
they were obviously able to do
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Inventory
DIO example
 ONNN has a long history of DIO around 80 days


But then there’s this move of +40 days
◦ Big acquisition (AMI Semi)
◦ Not really worrying if they can “work it down” – which
they were obviously able to do
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Inventory
Sometimes there is just a problem…
UTSI grew > 75% each of the first two
quarters of 2003…
 Having accelerated from the previous
year (around the 30-40% range)
 With the help of some acquisitions…
 And the stock had been awesome as the
revenue acceleration happened


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Inventory
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Inventory
• Inventories go nuts, up to $1b in 2Q03, equating to 374 days
• The inventories come down, but we later learn they’ve tried to move them
“OBS” (the # in row 264).
• UTSI – after clearing mgmt house – conducted a series of self investigations
regarding their accounting and business practices, and much mischief was
found
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Inventory
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Other “Cookie Jars”
“A disingenuous accounting practice in which periods
of good financial results are used to create reserves
that shore up profits in lean years. “Cookie jar
accounting” is used by a company to smooth out
volatility in its financial results, thus giving investors
the misleading impression that it is consistently
meeting earnings targets.” - Investopedia
 You can analyze DDR, or days of deferred revenue, on
a similar basis
 Warranties are another place to store expenses

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Other “Cookie Jars”
“One of the best-known cases of cookie jar accounting in recent years was
that of computer giant Dell, which in July 2010 agreed to pay a $100 million
penalty to the Securities and Exchange Commission (SEC) to settle SEC
allegations that it used cookie jar reserves. The SEC maintained that Dell
would have missed analysts’ earnings estimates in every quarter
between 2002 and 2006 had it not dipped into these reserves to
cover shortfalls in its operating results. The cookie jar reserves were
created through undisclosed payments that Dell received from chip giant Intel
in return for agreeing to use Intel’s CPU chips exclusively in its computers.
(Intel made these payments to Dell to lock out rival chipmaker Advanced
Micro Devices from Dell computers.)” - Investopedia
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Summary
Earnings (EPS) isn’t just a number – you
need to evaluate what’s behind it
 Most of the information necessary to
determine Earnings Quality is available
 The larger your sample (more periods),
the more insightful you can be
 Everything has context; the numbers are
clues, but you still need to piece together
what they are saying

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