When it comes to analyzing the sources of sustainable revenues, it helps to parse the “technical” factors (lower left-hand quadrant). These are often strangely neglected by investors.
The first technical factor is acquisitions. Take a look at this excerpt from a footnote in Office Depot’s annual report: (more…)
Let’s consider the two dimensions of revenue sources. The first dimension is cash versus accrual: we call this “cash” versus “maybe cash” (represented on the left side of the box below). “Maybe cash” refers to any booked revenue that is not collected as cash in the current period. (more…)
Of course, many sales are offered with credit terms: the product is sold and an accounts receivable is created. Because the product has been delivered (or service has been rendered) and payment is agreed upon, known, and reasonably assured, the seller can book revenue. (more…)
2. Check against Cash Collected The second thing you can do is to check reported revenues against the actual cash received from customers. In the section on cash flow, we see that companies can show cash from operations (CFO) in either the direct or indirect format; unfortunately, almost all companies use the indirect method.
The virtue of the direct method is that it displays a separate line for “cash received from customers.” Such a line is not shown under the indirect method, but we only need three items to calculate the cash received from customers: (more…)
Many of the companies that have restated their revenues sold products or services in some combination of the modes listed above under “difficult revenues.” In other words, the sales of these companies tended to involve long-term service contracts (making it difficult to determine how much revenue should be counted in the current period when the service is not yet fully performed), complex franchise arrangements, pre-sold memberships or subscriptions, and/or the bundling of multiple products and/or services. (more…)
Revenue recognition refers to a set of accounting rules that governs how a company accounts for its sales. Many corporate accounting scandals have started with companies admitting they have reported “irregular” revenues. This kind of dishonesty is a critical accounting issue. In several high-profile cases, management misled investors–and its own auditors–by deliberately reporting inflated revenues in order to buoy its company’s stock price. As of June 2004, the Financial Accounting Standards Board (FASB) has begun working to consolidate and streamline the various accounting rules into a single authoritative pronouncement. (more…)
4. Income from Continuing Operations (Net Income from Continuing Operations) This is the same as above, but taxes are subtracted. From a shareholder perspective, this is a key line, and it’s also a good place to start since it is net of both interest and taxes. Furthermore, it excludes the non-recurring items discussed above, which instead fall into net income but can make net income an inferior gauge of operating performance. (more…)
2. Operating Income after Depreciation and Amortization (EBIT) In theory, this is a good measure of operating profit. By including depreciation and amortization, EBIT counts the cost of making long-term investments. However, we should trust EBIT only if depreciation expense (also called accounting or book depreciation) approximates the company’s actual cost to maintain and replace its long-term assets. (Economic depreciation is the term used to describe the actual cost of maintaining long-term assets). For example, in the case of a REIT, where real estate actually appreciates rather than depreciates–that is, where accounting depreciation is far greater than economic depreciation–EBIT is useless. (more…)
Once the income statement is adjusted or corrected for timing differences, the other major issue is classification. In other words, which profit number do we care about? The question is further complicated because GAAP does not currently dictate a specific format for the income statement. As of May 2004, FASB has already spent over two years on a project that will impact the presentation of the income statement, and they are not expected to issue a public discussion document until the second quarter of 2005. (more…)
In this section, we try to answer the question, “what earnings number should be used to evaluate company performance?” We start by considering the relationship between the cash flow statement and the income statement. In the preceding section, we explained that companies must classify cash flows into one of three categories: operations, investing, or financing. (more…)