Learning from Financial Scandals

in Investment
Financial Scandals

The era of recent financial scandals has turned the spotlight on the need for more transparency, more disclosure, and more thorough analyses of available information.

When analyzing a company, investors and analysts alike focus on the company’s financial and operating performance. However, what makes any such analysis potentially flawed is the fact that information used is actually provided by someone else. Unless investors are willing to dig in deeper!

Financial reporting is the responsibility of public issuers. Financial information must be presented in a clear, easy to understand, relevant, reliable and comparable manner.

What makes the disclosed information relevant is its transparency, and more importantly, its accuracy.

A bounty of information is made available on any given day. Unfortunately, while there are companies that choose to go above and beyond the minimum required disclosures, there are also quite a few companies that go well below them. This is where looking at the presented information critically becomes a necessity.

Understand the Type of Disclosure

Not only analysts, but ordinary investors as well should be knowledgeable about the type of information they are using in their analyses.

  1. The first question is to find out if financial disclosure has been prepared according to some generally accepted accounting principles.
  2. The next question should be how well investors and analysts understand the type of disclosure they are looking at.

If the disclosure is about earnings, investors should be able to distinguish among the various “types” of earnings; that is, whether the management is talking about EBITDA (earnings before interest, taxes, depreciation and amortization), or income from operations (EBIT), or income before taxes (EBT), or net income, and so forth.

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This surely sounds complicated, and many investors might view many of these classifications as unnecessary, perhaps even as a way to obscure disclosure, rather than to increase its transparency.

Bear in mind, however, that financial disclosure should be clear and understandable to both laymen and industry experts, which is why it may be prudent to separate transitory information from permanent items that may have long-term fundamental impact.

Always Read the Small Print

The most popular sources of financial information are financial statements: balance sheet, income statement and statement of cash flows. But there is a sea of information in other types of disclosures, specifically in footnotes, the management discussion and analysis (MD&A), and other sources.

In fact, the general consensus now is to start financial analysis with the footnotes, as these typically contain disclosures about accounting policies applied in the “big print.”

The only problem is the lack of presentation standards when it comes to footnotes, since these are often neither easy to understand nor clearly presented.

If Something Looks Too Good to Be True, That’s Perhaps Because It Is

Over the years, many corporations have actually lived through their American Dreams. Who does not remember the humble beginnings of Microsoft or Wal-Mart and their subsequent rise to fame.

Of course, success neither came easily nor without a reason. Each of the success stories have had some sort of comparative or competitive advantage over its peers that they were able to exploit.

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The key thing to remember is that success stories are very rare. In the study “The Level of Persistence of Growth Rates,” by Louis K.C. Chan, Jason Karce ski, and Joseph Lakonishok, (Journal of Finance 58), the following was observed in the period from 1951 to 1998:

  • earnings grew at the median rate of ten percent per year;
  • only three percent of companies grew above that median rate for five consecutive years;
  • growth rates after dividends mirrored GDP growth rates between three percent and 3.5%;
  • only five percent of companies grew at rates over 30% per year;
  • revenue growth rates did not necessarily result in similar earnings growth rates;

So, if the company appears too good to be true, it just might be that it is just that – too good to be true!

Understand Multiple Layers of Risk

Finally, there are many types of risk that a company deals with on a daily basis.

Financial, business, sales, foreign exchange, credit and other types of risks cannot be completely avoided; it is simply nature of the beast.

However, what matters immensely is how those risks are managed by the company.

Many companies engage in transactions intended to offset risks, or at least to reduce them to manageable levels. For example, to minimize interest rate risks, companies might enter into interest rate swaps.

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Or, to lock in today the future prices of commodities, companies might enter into forward contracts. A prudent investor or analyst would do well to examine a company’s hedging activities, what they mean, as well as what they are intended to accomplish.

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