Company books are never cooked evenly—at
least some of the numbers are real.
It's more like they've been
microwaved for a few minutes on high rather than baked at 325 degrees
until done to perfection. Perhaps the most egregious example of this
is Enron, whose saga, along with its master chefs Lay, Skilling, and
Fastow, has been beaten to death in the financial press. For all the
coverage, hard analysis of the numbers has been hard to find. By
putting financial statements under the microscope, you have a chance
to spot suspect numbers and cash out of investments whose accounting
practices are questionable. Analyzing Enron's and
WorldCom's financial statements can help you learn
what to look for—and avoid.
Earnings are the obvious number to cook, because
that's what the market pays attention to. A good
place to start hunting for numbers that don't make
sense is the balance sheet: a statement of a
company's assets, liabilities, and
shareholders' equity. The tenacious financial chef
can make balance sheets lie, but companies rarely fudge their balance
sheets because Wall Street simply doesn't pay that
much attention to them. For that reason, you have a better chance of
uncovering the truth about a company's cash flow by
comparing successive balance sheets to determine where the money came
from and where it went during a particular period. The cash flow
analysis offered by the Spredgar analysis application
flow statement found in 10-K and 10-Q filings, but it points out
problems you might not catch otherwise.
Enron's Financial End Run
Most Wall Street firms had Enron as a strong buy up until the
company filed for bankruptcy. Apparently, the analysts
weren't doing much analyzing during this period.
Instead, they were mostly cheerleading—on the
company's behalf, their firm's,
and, ultimately, their own.
During the bull market, analysts seemed to be everywhere. Analysts
pumping stocks brought to their brokerage firms lucrative investment
banking deals, which in turn fattened the analysts'
paychecks with bonuses calculated mostly by the amount of investment
banking business they generated. Now, fewer analysts than ever cover
stocks, because stock analysts have recently become part of brokerage
cost centers rather than profit centers.
Enron's balance sheet smelled a bit overcooked as
far back as 1997. Looking at the comparison of
Enron's EPS to the cash flow that the company
generated, shown in , earnings were
positive 15 out of 16 quarters, but cash flow was in the black only
three times during the same period. Remember from the introduction to
that net income from the bottom of
the income statement appears at the top of the statement of cash
flows. So, where did the earnings go?
Figure 1. The Spredgar application's comparison of EPS and the free cash flow it generates
Let's take a closer look at the September 1997
quarter, in which earnings per share were a positive 17 cents a
share, whereas free cash flow was a whopping negative $7.82. The cash
flow statement generated by Spredgar in
shows a company that required $5.9 billion (cell L134) in net
investment activity and $6.2 billion (cell N134) in net financing
activity to generate only $134 million in net income (cell D133)! Its
return on equity (ROE) during the period was a meager 2.7
percent—using bogus numbers!
Figure 2. The Spredgar cash flow statement shows numbers that don't bode well for Enron
Judging from this figure, a significant amount of stock and bonds
have been issued. But what are these stocks and bonds actually
financing? Given the almost $6 billion flowing to investments, they
are finding investments of some kind. Although the authorities are
still sorting through the financial wreckage, we now know about
special purpose entities (SPEs), which hid
Enron's debt. Enron would transfer an asset (often
of dubious value) and its associated debt to a subsidiary. The parent
company would receive a note payable in return, which would show up
as an "investment" on
Enron's balance sheet. GAAP rules permitted the debt
to stay off Enron's balance sheet as long as
outsiders (in this case, usually Enron top management) had at least a
three percent ownership of the SPE.
We also know that Enron stock was transferred to these SPEs, which
also created a note payable to the parent. It might have been
possible for the SPEs to sell off some of that stock, thus generating
phony income back to the parent and possibly some for the outside
investors. As long as the stock price stayed up, the financial house
of cards was more or less intact. When the Wall Street
Journal scrutinized the SPEs in late 2001, a falling stock
price hastened Enron's demise.
WorldCom's Approach to Cooking the Books
WorldCom spun a similar tale to Enron in terms of
fudging the financials. In WorldCom's case, it was a
ploy of capitalizing some costs instead of recording them properly as
expenses, which (surprise!) resulted in higher reported earnings.
How so? It stems from how capitalization and depreciation affect a
company's earnings. When a company spends a big wad
of money to purchase equipment or other things that it will use over
a long period of time, the big wad of money doesn't
show up as an expense on the income statement. If it did, earnings
would take a huge hit in the year of the purchase, and then would
look particularly good for all the remaining years when the equipment
helps the company make money with no expenses to match. Depreciation
is an accounting mechanism that, in effect, spreads the cost of a
capitalized purchase over the useful life of the asset. The purchase
cost appears as a use of cash on the cash flow statement; the value
of the asset shows up on the balance sheet; and each year of the
equipment's useful life, a depreciation expense
appears on the income statement. Let's look at a
simple example. If a company has revenues of $100,000 and expenses of
$50,000, its net income is $50,000. However, if the company plays
games and transforms the $50,000 in expenses into capitalized
expenditures, the straight-line depreciation assuming no salvage
value would be one-fifth of the $50,000 for five years. This ploy
increases the net income to $90,000 for the year.
As we did with Enron, let's compare
WorldCom's EPS to free cash flow. shows a Spredgar comparison from September
1998 through September 2000. Except for two periods, free cash flow
is negative—and often dramatically less than reported positive
Figure 3. WorldCom's EPS looks much better than the cash flow it generates
How is this possible? Let's take a look at
Spredgar's net balance sheet cash flow for the
quarter ending December 1998, shown in .
WorldCom's expenses most likely show up in the
Property, plant, and equipment (PP&E) line item (cell D93).
During this period PP&E was more than five
times reported net income! This number
doesn't represent long-term assets and investments,
which are listed on the next line. From eight quarters starting in
October 1998, PP&E ranged from 80 to 400 percent of net income.
Stuffing expenses into this area enabled WorldCom to report net
income as positive, while the correct categorization of expenses
resulted in a loss.
Figure 4. WorldCom's cash flow shows results not often seen in legitimate businesses
Because of WorldCom's capitalization games,
depreciation (cell D104) is higher than net income for the period. If
you're capitalizing expenses, you must depreciate
and amortize them, which results in high depreciation and
amortization expenses. This is not likely to happen to a legitimate
business, because it implies purchases of assets that
don't produce sufficient income. However, for the
next seven quarters, WorldCom's depreciation and
amortization ran between 30 and 100 percent of net income
Because these evasive tricks do appear from time to time, you can
compare financial measures to industry averages and #34] to
highlight numbers that appear out of whack. For example,
WorldCom's return on equity averaged 3.6 percent
during this period compared to AT&T's ROE of
over 13 percent. Asset turnover
compares even worse, with WorldCom's at .1 and
AT&T's at .7 (seven times higher).
By using tools such as Spredgar, you can scrutinize numbers to find
good explanations or perhaps bad business practices. If the numbers
don't give you the answers you're
looking for, call investor relations and ask them to explain. And, if
those answers aren't much help, perhaps
it's time to find another company.