Many years ago a British bank chairman observed that not only did the bank’s accounts show its true position but the actual situation was a little better still. Since that time accounting standards have been much more carefully defined, but companies still have considerable discretion in calculating profits and deciding what to show in the balance sheet. Thus when you calculate financial ratios, you need to look below the surface and understand some of the pitfalls of accounting data. The nearby box discusses some ways in which companies can manipulate reported earnings.
For example, the assets shown in Pepsi’s 1998 balance sheet include a figure of
$8,996 for “intangibles.” The major intangible consists of “goodwill,” which is the difference between the amount that Pepsi paid when it acquired several companies and the book value of their assets. Pepsi writes off a proportion of this goodwill from each year’s profits. We don’t want to debate whether goodwill is really an asset, but we should warn you about the dangers of comparing ratios of firms whose balance sheets include a substantial goodwill element with those that do not.
Another pitfall arises because many of the company’s liabilities are not shown in the balance sheet at all. For example, the liabilities include leases that meet certain tests—for example, leases lasting more than 75 percent of the leased asset’s life. But a lease lasting only 74 percent of asset life escapes the net and is shown only in the footnotes to the financial statements. Read the footnotes carefully; if you take the balance sheet uncritically, you may miss important obligations of the company.
CHOOSING A BENCHMARK
We have shown you how to calculate the principal financial ratios for Pepsi. In practice you may not need to calculate all of them, because many measure essentially the same thing. For example, if you know that Pepsi’s EBIT is 8.0 times interest payments and that the company is financed 39 percent with long-term debt, the other leverage ratios are of relatively little interest.
Once you have selected and calculated the important ratios, you still need some way of judging whether they are high or low. A good starting point is to compare them with the equivalent figures for the same company in earlier years. For example, you can see from the first two columns of Table A.13 that while Pepsi was somewhat more profitable in 1998 than in the previous year, it was also substantially less liquid. It had negative working capital and a much lower cash ratio than in 1997.
It is also helpful to compare Pepsi’s financial position with that of other firms. However, you would not expect companies in different industries to have similar ratios. For example, a soft drink manufacturer is unlikely to have the same profit margin as a jeweler or the same leverage as a finance company. It makes sense, therefore, to limit comparison to other firms in the same industry. For example, the third column of Table A.13 shows the financial ratios for Coca-Cola, Pepsi’s main competitor.12 Notice that Coke is also operating with negative working capital, but, unlike Pepsi, it has very little longterm debt.
When making these comparisons remember our earlier warning about the need to dig behind the figures. For example, we noted earlier that Pepsi’s balance sheet contains a large entry for goodwill; Coke’s doesn’t, which partly explains why Coke has the higher return on assets.
Financial ratios for industries are published by the U.S. Department of Commerce, Dun & Bradstreet, Robert Morris Associates, and others.
Think of a Number
The quality of mercy is not strain’d; the quality of American corporate profits is another matter. There may be a lot less to the published figures than meets the eye. Warren Buffett, America’s most admired investor, certainly thinks so. As he sagely put it recently, “ A growing number of otherwise high-grade managers— CEOs you would be happy to have as spouses for your children or as trustees under your will— have come to the view that it is OK to manipulate earnings to satisfy what they believe are Wall Street’s desires. Indeed many CEOs think this kind of manipulation is not only OK, but actually their duty.”
The question is: do they under- or overstate profits? Unfortunately different ruses have different effects. Take first those designed to flatter profits. Thanks mainly to a furious lobbying effort by bosses, stock options are not counted as a cost. Smithers & Co., a London-based research firm, calculated the cost of these options and concluded that the American companies granting them had overstated their profits by as much as half in the 1998 financial year; overall, ignoring stock-option costs has exaggerated American profits as a whole by one to three percentage points every year since 1994.
Then there are corporate pension funds. The value of these has soared thanks to the stock market’s vertiginous rise and, as a result, some pension plans have be-
come overfunded (assets exceed liabilities). Firms can include this pension surplus as a credit in their income statements. Over $1 billion of General Electric’s reported pretax profits of $13.8 billion in 1998 were “ earned” in this way. The rising value of financial assets has allowed many firms to reduce, or even skip, their annual pension-fund contributions, boosting profits. As
pension-fund contributions will almost certainly have to be resumed when the bull market ends, this probably paints a misleading impression of the long-term trend of profitability.
Mr. Buffett is especially critical of another way of dampening current profits to the benefit of future ones: restructuring charges (the cost, taken in one go, of a
corporate reorganization). Firms may be booking much bigger restructuring charges than they should, creating a reserve of money to draw on to boost profits in a difficult future year.
For example, the assets shown in Pepsi’s 1998 balance sheet include a figure of
$8,996 for “intangibles.” The major intangible consists of “goodwill,” which is the difference between the amount that Pepsi paid when it acquired several companies and the book value of their assets. Pepsi writes off a proportion of this goodwill from each year’s profits. We don’t want to debate whether goodwill is really an asset, but we should warn you about the dangers of comparing ratios of firms whose balance sheets include a substantial goodwill element with those that do not.
Another pitfall arises because many of the company’s liabilities are not shown in the balance sheet at all. For example, the liabilities include leases that meet certain tests—for example, leases lasting more than 75 percent of the leased asset’s life. But a lease lasting only 74 percent of asset life escapes the net and is shown only in the footnotes to the financial statements. Read the footnotes carefully; if you take the balance sheet uncritically, you may miss important obligations of the company.
CHOOSING A BENCHMARK
We have shown you how to calculate the principal financial ratios for Pepsi. In practice you may not need to calculate all of them, because many measure essentially the same thing. For example, if you know that Pepsi’s EBIT is 8.0 times interest payments and that the company is financed 39 percent with long-term debt, the other leverage ratios are of relatively little interest.
Once you have selected and calculated the important ratios, you still need some way of judging whether they are high or low. A good starting point is to compare them with the equivalent figures for the same company in earlier years. For example, you can see from the first two columns of Table A.13 that while Pepsi was somewhat more profitable in 1998 than in the previous year, it was also substantially less liquid. It had negative working capital and a much lower cash ratio than in 1997.
It is also helpful to compare Pepsi’s financial position with that of other firms. However, you would not expect companies in different industries to have similar ratios. For example, a soft drink manufacturer is unlikely to have the same profit margin as a jeweler or the same leverage as a finance company. It makes sense, therefore, to limit comparison to other firms in the same industry. For example, the third column of Table A.13 shows the financial ratios for Coca-Cola, Pepsi’s main competitor.12 Notice that Coke is also operating with negative working capital, but, unlike Pepsi, it has very little longterm debt.
When making these comparisons remember our earlier warning about the need to dig behind the figures. For example, we noted earlier that Pepsi’s balance sheet contains a large entry for goodwill; Coke’s doesn’t, which partly explains why Coke has the higher return on assets.
Financial ratios for industries are published by the U.S. Department of Commerce, Dun & Bradstreet, Robert Morris Associates, and others.
Think of a Number
The quality of mercy is not strain’d; the quality of American corporate profits is another matter. There may be a lot less to the published figures than meets the eye. Warren Buffett, America’s most admired investor, certainly thinks so. As he sagely put it recently, “ A growing number of otherwise high-grade managers— CEOs you would be happy to have as spouses for your children or as trustees under your will— have come to the view that it is OK to manipulate earnings to satisfy what they believe are Wall Street’s desires. Indeed many CEOs think this kind of manipulation is not only OK, but actually their duty.”
The question is: do they under- or overstate profits? Unfortunately different ruses have different effects. Take first those designed to flatter profits. Thanks mainly to a furious lobbying effort by bosses, stock options are not counted as a cost. Smithers & Co., a London-based research firm, calculated the cost of these options and concluded that the American companies granting them had overstated their profits by as much as half in the 1998 financial year; overall, ignoring stock-option costs has exaggerated American profits as a whole by one to three percentage points every year since 1994.
Then there are corporate pension funds. The value of these has soared thanks to the stock market’s vertiginous rise and, as a result, some pension plans have be-
come overfunded (assets exceed liabilities). Firms can include this pension surplus as a credit in their income statements. Over $1 billion of General Electric’s reported pretax profits of $13.8 billion in 1998 were “ earned” in this way. The rising value of financial assets has allowed many firms to reduce, or even skip, their annual pension-fund contributions, boosting profits. As
pension-fund contributions will almost certainly have to be resumed when the bull market ends, this probably paints a misleading impression of the long-term trend of profitability.
Mr. Buffett is especially critical of another way of dampening current profits to the benefit of future ones: restructuring charges (the cost, taken in one go, of a
corporate reorganization). Firms may be booking much bigger restructuring charges than they should, creating a reserve of money to draw on to boost profits in a difficult future year.
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