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problems.
year incentives.
If free cash flow to equity (FCFE) (which equals cash flow from operations minus cash flow from investments) is growing more than earnings, it may be a good sign. (Conversely, a FCFE that grows less than earnings may be a bad sign.)
In the long-run, it is unlikely that divergence between the two can be sustained--eventually, earnings will probably converge with the cash flow trend.
The funded status of a pension plan, which equals the fair value of plan assets minus the projected benefit obligation (PBO), tends to impact future earnings.
Unless trends reverse, under-funded (over-funded) pension plans will require greater (fewer) contributions in the future.
Red Flags Theme
The red flags emphasized in this tutorial stem from this single principle: the aim in analyzing financial statements is to isolate the fundamental operating performance of the business. In order to do this, you must remove two types of gains that may not be sustainable:
1. Non-recurringgains-Theseincludegainsduetothesaleofabusiness,one- time gains due to acquisitions, gains due to liquidation of older inventory (that is, liquidation of the LIFO layer), and temporary gains due to harvesting old fixed assets (where lack of new investment saves depreciation expense).
2. Gainsduetofinancing-Theseareimportantbecause,whiletheyarereal gains, they are often random variables that depend on market conditions and they may be reversed in future years.
The sources of financing gains include special one-time dividends or returns on investments, early retirement of debt, hedge or derivative investments, abnormally high pension plan returns (including an upward revision to expected return on plan assets, which automatically reduces pension cost), and increases to earnings or EPS simply due to a change in the capital structure (for example, an increase in EPS due to an equity-for-debt swap).
Green Flags Theme
In regard to green flags, the key principle--as far as financial statements are concerned--is that it is important to see conservative reporting practices. In regard to the two most popular financial statements, conservatism is implied by the following:
1. Intheincomestatement:Conservativerevenuerecognitionisshownby things like no barter arrangements, no front-loaded recognition for long-term contracts, a sufficient allowance for doubtful accounts (that is, it is growing with sales), the choice of LIFO rather than FIFO inventory costing method, and the expensing of rather than capitalizing of R&D expenditures.
2. Inthebalancesheet:Conservativereportingpracticesincludesufficientcash balances; modest use of derivative instruments that are deployed only to hedge specific risks such as interest rate or foreign currency exchange; a capital structure that is clean and understandable so those analyzing the
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