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TEAMFLYTeam-Fly®ESSENTIALSofFinancialAnalysisGeorgeT.FriedlobLydiaL.F.SchleiferJohnWiley&Sons,Inc.Copyright©2003byGeorgeT.FriedlobandLydiaL.F.Schleifer.Allrightsreserved.PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.PublishedsimultaneouslyinCanadaNopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopy-rightAct,withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,MA01923,978-750-8400,fax978-750-4470,oronthewebat:permcoordinator@wiley.com.LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbesteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttotheaccuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimpliedwarrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybecreatedorextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategiescontainedhereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessionalwhereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofprofitoranyothercommercialdamages,includingbutnotlimitedtospecial,inci-dental,consequential,orotherdamages.Forgeneralinformationonourotherproductsandservices,ortechnicalsupport,pleasecontactourCustomerCareDepartmentwithintheUnitedStatesat800-762-2974,out-sidetheUnitedStatesat317-572-3993orfax317-572-4002.Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsinprintmaynotbeavailableinelectronicbooks.LibraryofCongressCataloging-in-PublicationData:Friedlob,G.Thomas.Essentialsoffinancialanalysis/GeorgeT.Friedlob,LydiaL.F.Schleifer.p.cm.—(Essentialsseries)Includesbibliographicalreferencesandindex.ISBN0-471-22830-3(pbk.:alk.paper)1.Financialstatements.2.Corporationreports.3.Financialstatements—UnitedStates.4.Corporationreports—UnitedStates.I.Schleifer,LydiaL.F.(LydiaLancasterFolger),1955-II.Title.III.Series.HG4028.B2F752003332.63′2042—dc212002012427PrintedintheUnitedStatesofAmerica10987654321iiiContentsPrefaceiv1UnderstandingFinancialStatementsandAnnualReports12AnalyzingProfitability333AnalyzingLiquidityandSolvency714AnalyzingActivitywithFinancialandNonfinancialMeasures1215QualityofEarningsandCashFlows1456EarningsReleasesandEVAAnalysis1757E-Business207Notes226Index229ivPrefaceThefinancialanalysisofcompaniesisusuallyundertakensothatinvestors,creditors,andotherstakeholderscanmakedecisionsaboutthosecompanies.Thefocusofthisbookisonthefinancialanalysisofcompaniesthatarepubliclytradedandthereforemakepublicthedataandinformationneededbystakeholders,whocanthenusetheanalyticalproceduresincludedinthisbook.Theprimaryobjectivesinthisbookareto•Provideanoverviewoffinancialstatementsandwhereandhowtoobtainthem.•ExplainhowtousetheinformationprovidedinannualreportsandSecuritiesandExchangeCommission(SEC)filings,toexamineacompany’sprofitability,liquidity,andsolvency.•Examinevarioustechniquesforevaluatingthemarketvalueofcompaniesbasedontheirfinancialreportsandstockprices.•Discussissuesrelatedtothequalityofearningsandfinancialreporting.•Describeseveralwaysofexaminingthecashflowsofcompanies.•Describenewdevelopmentsinareaslikeproformareporting,economicvalueadded(EVA),anddiscountedcashflowmethods.vPrefaceChapter1startsbylookingbrieflyathowaccountingforresourcesbegan.Then,anexampleofasetoffinancialstatements(forCoca-ColaCompany)isincludedandtheircontentexplained.Followingthatisacomparisonofcash-basisandaccrual-basisaccounting.Chapter2looksatprofitabilityfrommanyangles.Profitsarereportedontheincomestatement,sowestartwithalookatthecate-goriesofearningsontheincomestatement.Thechapterdiscussesoper-atingincomeandcomprehensiveincomeandwheretofindthatinformation.Becauserevenuerecognitionissomuchinthespotlightlately,thebasicsofthatprinciplearediscussed.Fourofthemainanalyt-icaltechniquesusedbyfinancialanalystsareincluded:returnonassets(ROA),returnonequity(ROE),earningspershare(EPS),andtheprice/earnings(P/E)ratio.Chapter3examinestheconceptsofliquidityandsolvencyandhowtoevaluatethoseattributesforacompany.Theprimaryfocusisonthebalancesheet.However,alsoincludedaresomecashflowadequacyratios,sincelackofcashflowcanforcecompaniestodeclarebankruptcy.Thechapterdiscusseshowleveragecanaffectacompany.Alsoincludedisadiscussionoftheauditor’sdecisionprocesswhenevaluatinggoingconcernstatus.Finally,weincludeademonstrationoftheuseofAltman’sZscore.Chapter4examinestheactivity,effectiveness,andproductivitymea-suresthatcanbeusedtoevaluatecompanies.Thechapterdiscussessev-eralturnoverratios,likeaccountsreceivableandinventoryturnover.Italsodiscussesamethodofanalyzingcapacityusageandhowtocalculateoperatingleverageand