Leases, Retirement Obligations and Receivables Accounting

Leases, pension obligations and securitized receivables are like debt obligations.

Accounting rules can allow them to be off-balance-sheet items.

Such items can bias ROIC upward, which makes competitive benchmarking unreliable.

However, valuation may be unaffected.



Operating Leases Accounting

Adjust for operating leases:

• recognize the lease as both an obligation and asset on the balance sheet (which requires an increase in operating income by adding an implicit interest expense to the income statement and lowering operating expenses by the same amount),
• adjust WACC for the new leverage ratios, and 
• value the company based on the new free cash flow and WACC  

Assuming straight-line depreciation, an estimate of a leased asset's value for the balance sheet is:

Asset Value at time t-1 = Rental Expense at time t / [ kd + (1/Life of the Asset)]

kd = cost of debt




Receivables Accounting

(a) When company sells a portion of its receivables

Another source of distortion occurs when a company sells a portion of its receivables.

This reduces accounts receivable on the balance sheet and increases cash flow from operations on the cash flow statement.

Despite the favourable changes in accounting measures, the selling of receivables is very similar to increasing debt because

• the company pays fees for the arrangement,
• it reduces its borrowing capacity, and 
• the firm pays higher interest rates on unsecured debt.

(b) Securitized receivables

In the wake of the financial crisis of 2007, accounting policy has tightened.

Securitized receivables are now classified as secured borrowing.

In these situations, no adjustment is required

In the infrequent cases where securitized receivables are not capitalized on the balance sheet,

• add back the securitized receivables to the balance sheet and 
• make a corresponding increase to short-term debt.

These alterations will determine the necessary changes to return on capital, free cash flow, and leverage.

Interest expense should increase by the fees paid for securitizing receivables.



Pension Accounting

Companies must report excess pension assets and unfunded pension obligations on the balance sheet at their current values, but pension accounting can still greatly distort operating profitability.

Three steps should be taken to incorporate excess pension assets and unfunded pension liabilities into enterprise value and the income statement to eliminate accounting distortions.  

These three steps are:

1. identify excess pension assets and unfunded liabilities on the balance sheet,
2. add excess pension assets to and deduct unfunded pension liabilities from enterprise value, and
3. remove the accounting pension expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

Much of the necessary information for this process appears in the company's notes.

Number of days' credit granted

For example:

Annual turnover including GST  $10 million
Trade debtors $1.5 million
Number of days' credit  55

The calculation is:  (1.5 / 10) x 365 = 55 days

Obviously, the lower the number of days the more efficiently the business is being run.

The figure for trade debtors normally comes from the closing Balance Sheet and care should be taken that it is a figure typical of the whole year.

If $1.5 million of the $10 million turnover came in the final month, the number of days' credit is really 31 instead of 55.

The calculation is:  (1.5 / 1.5 ) x 31 = 31 days

Care should also be taken that the GST-inclusive debtors figure is compared with the GST-inclusive turnover figure.

GST is normally excluded from the Profit and Loss Account.



GST = General Sales Tax
In other countries, it is the VAT or Value Added Tax.

3 Investing Traps -- And How To Avoid Them

These tips should help you sidestep some common accounting pitfalls.

Alcoholics have 12 steps. Grievers have five stages. Investors have their phases, too, with the biggest leap coming when a fledgling shareholder begins tossing accounting ratios around. I've calculated ratios for years myself, both as a hedge-fund analyst and in making share recommendations for The Motley Fool, and I'll say this: ratios are both powerful and open to misuse by novices. I'd like to share a few tricks with you to help you avoid some common pitfalls.

Trap 1: Focusing too much on return on equity (ROE)

The much-vaunted ROE seems pure: take net profits, divide by shareholders' equity, and you see how efficient a business is with investors' money. ROE is Warren Buffet's favourite ratio, and executive pay is sometimes tied to it.

When it's a trap: When it's enhanced by debt. Borrowing funds to make more money for shareholders isn't necessarily evil, and is sometimes beneficial. But investors strictly watching ROE will miss the additional risk taken by a management team 'gearing up' to meet performance targets.

Protect yourself: Add return on invested capital (ROIC) to your arsenal. Using the same principle as ROE, ROIC essentially compares after-tax operating profits to both debt and equity capital, and thus provides a better measure of operational success that can't be inflated by a financing decision. Moreover, research by American equity strategist Michael Mauboussin of Legg Mason shows that companies whose ROICs either rise or remain consistently high tend to outperform others. Search online to find the precise formula, or drop me a comment in the box below.

Using Standard & Poor's Capital IQ database, I screened for companies with returns on capital (a near-identical cousin of ROIC) above 20% that have seen an improvement in return on capital during the past five years. These shares are not recommendations, but rather screen results that may be of interest given the discussion.

Company	Market cap (£m)	Return on capital
		Last fiscal year	Five years ago
Croda International (LSE: CRDA)	2,638	26.3%	22.8%
Renishaw (LSE: RSW)	1,053	25.1%	16.9%
Burberry (LSE: BRBY)	6,172	24.4%	20.0%

Trap 2: Taking turnover growth at face value

A sale is a sale, right? Wrong. Turnover is a prime line for accounts manipulation.

When it's a trap: Intricate shenanigans with turnover figures can be tough to uncover, but a simple rule of thumb is to become suspicious if growth in trade receivables (for instance, the amounts customers owe) meaningfully exceeds growth in revenues. This could indicate 'channel stuffing', whereby a company extends overly generous terms to customers simply to gain a short-term turnover boost.

Protect yourself: Using a screening tool or your own sums, compute the relative growth of both sales and trade receivables, particularly for companies whose growing turnover forms a major part of your investing thesis.

Again using Capital IQ, I noticed retailer Dunelm (LSE: DNLM) reported attractive 9% growth in sales last year (especially in this consumer market) -- albeit accompanied by a troubling 22% increase in trade receivables. While not a red flag outright, it's something to investigate further.

Trap 3: Using accounting profits to compute dividend cover

I've done this myself, and feel it's probably acceptable with stable companies clearly able to pay shareholders.

When it's a trap: The first thing a budding investor learns is that for accounting reasons, profits don't always match cash flow -- from which dividends are paid. Though cash flows and profits should theoretically match over time, profits are skewed by 'accrual' calculations, such as spreading the cost of equipment purchases over the life of the equipment, versus charging the costs in the year they occurred.

Protect yourself: Experienced analysts use free cash flow instead of reported earnings to produce a more reliable measure of dividend safety. Read this old-school Fool article for a moredetailed discussion on free cash flow. Swapping cash flow for accounting profits in your dividend cover calculation should increase its reliability.

Capital IQ turned up these companies as having cash flows materially exceeding accounting profits.

Company	Net profits (£m)	Free cash flow (£m)
Marks & Spencer (LSE: MKS)	603	701
Sage Group (LSE: SGE)	189	283
Rexam (LSE: REX)	154	265

There you have it. You're now three traps wiser, which is a step ahead of most investors. Indeed, while spotting numerical chicanery may be best for sidestepping share-price stinkers, avoiding losers is more than half the battle to building a winning portfolio.

http://www.fool.co.uk/news/investing/2012/02/02/3-investing-traps-and-how-to-avoid-them.aspx?source=ufwflwlnk0000001

How to Analyze Receivables & Inventory

How to Analyze Receivables & Inventory

Thu, Feb 11, 2010

Featured, Stock Analysis

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How to Perform Inventory and Receivables Anlaysis

I wanted to go through a quick exercise that I perform during a stock analysis.

A recent stock that has come up in the Graham stock screener and forum is CONN. Conn’s Inc is a specialty retailer of home appliances such as fridges, freezers, washers, dryers and consumer electronics such as TV’s, cameras, computers etc. Think Best Buy.

The company just released their results for their 2009 4th quarter results and the stock took a 17%hit. The actual financial statements hasn’t been released but I wanted to show how these things are foreseeable by analyzing the inventory and accounts receivables. This has also been discussed in the balance sheet analysis.

Sales, Inventory and Receivables Analysis

For any company that sells products, a careful look at the correlation between sales, accounts receivables and inventories is crucial. In the above example, I’ve only compared the 3rd quarter statements but you can see that CONN does not know how to manage their assets.

From what I see, the problem began to surface in 2006 where revenue only increased 0.23% while accounts receivables increased 31% and inventory went up 8%. Before 2006, the company was able to grow revenues at a faster rate than accounts receivables and inventory but from 2006 onwards, the correlation worsened until 2008 where you can immediately see that things were bound to fall apart.

In 2008, revenues declined 3% compared to the previous comparable period while accounts receivables increased by 116% and inventories up 9%.

The same thing happened in 2009 where accounts receivables increased another 102%! The only thing waiting for CONN is trouble, and it finally surfaced in their latest quarter. It goes to show that Wall Street does not perform the proper analysis required.

Here is a graphical view of the same thing.

Whenever you see either accounts receivables of inventory increase quicker than sales, watch out. But for inventory, you need to dig deeper.

When raw materials component of inventories is advancing much  more rapidly than the work-in-progress and finished goods components, this means that the company is receiving many new orders and an inventory buildup is necessary. So the company will simultaneously ship products from its finished goods inventory while ordering raw materials in larger amounts.

But in the case of CONN, the company only sells the items so 100% of inventory is finished goods so any excessive increase is a big red warning sign.

Dirt Cheap or Value Trap

All valuations point to a cheap company. Looks like the intrinsic value is roughly $15-$16.

If I had come across CONN when I first started investing, I’m pretty sure I would have bought it. At today’s price of $4.61 it is definitely cheap and tempting but until there are signs that management is able to get a handle on inventory and accounts receivables, it is best to leave it alone.

Sure the stock can go up, but it doesn’t hide the fact that the company is struggling. CONN has also increased their accounts payables and taken on huge amounts of long term debt.

If I was to buy the stock now, I would only be speculating and hoping that things improve.

http://www.oldschoolvalue.com/stock-analysis/inventory-receivables-analysis-conn/