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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Understanding Financial Statements Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions


Balance Sheet Analysis

 - Leverage and financial
   strength affect share value

 - Liquidity concerns can
   decimate a business

 - Cash is critical, to a point
    * Window Dressing
    * Cash Gap
    * Cash per Share
    * Burn Rate

 - Marketable Securities

 - Receivables are interwoven
    with cash flow
    * Past Dues and Write-offs
    * Receivables turnover ratios
    * Securitizations

 - Inventory - focus on the
   profit margins
    * Perpetual vs. Periodic
       Inventory
    * Inventory Accounting
       Calculation
    * Inventory Costing Methods
    * Lower of Cost of Market
    * Inventory Categories
    * Inventory Turnover Ratios

 - Fixed assets are necessary in
   order to be a world class
   company

 - Liabilities with equity attributes
   are enriching

 - Emphasizing debt net of cash
   can be misleading

 - Book value is a tool to
    properly evaluate a stock

 - Off-balance sheet assets and
   liabilities are legal

 

 


Off-balance sheet assets and liabilities are legal

Investors first need to realize that off-balance-sheet items are not new, and have been in existence for many years. Some of the high-profile cases in the news, that stretch the accounting fabric to its limits, are highlighting to many first-generation investors, the sophistication and complexities of business transactions.

Many routine transactions are handled off-balance-sheet until the obligations have been met. For example, unfulfilled executed purchase orders are not recorded until the merchandise has been received. Standard employment contracts are usually recorded through payroll when paid. Consulting contracts are normally accrued when the services are rendered. These routine unrecorded extended term obligations are common business practices, where future liabilities go unreported as of a balance sheet date. Additionally, the whole area of contingent liabilities is not recorded on the actual financial statements. In most cases, these are “nice to know” items, but should not affect one’s investment decisions. 

Operating leases, while disclosed and scheduled out, are usually not recorded on the books until payments are due. Briefly, operating leases are those leases where the risk of ownership stays with the manufacturer or owner. The lessee does not record the asset, or the liability, but records the expense when used or paid. In effect, operating leases keep assets & debt off the balance sheet. Most office copier leases are treated this way. They are expensed when paid, yet the contract may extend out 3 to 5 years. Office leases are treated similarly. In some cases, one can argue that the balance sheet is misleading, but investors should be responsible enough to read the footnotes of the stocks they own. Theoretically, an airline company can have a balance sheet showing no airplanes as fixed assets and no associated debt. The rental obligations would be disclosed and scheduled out in the operating lease footnote.  Investors need to realize that required operating lease payments should be considered debt, regardless of their accounting classification. The accounting profession and the government are reviewing the accounting for operating leases.

Securitizations have become another area of potential conflict. Companies structure them as both on-balance-sheet, as well as off-balance-sheet transactions. For those unfamiliar with the term, it is taking illiquid assets, in most cases accounts or notes receivable, transferring them to an unconsolidated subsidiary, converting the assets into securities and selling them off. In many cases the numbers are material, especially for financial institutions. New comprehensive disclosure rules in this area are being developed. Finance professionals have been debating for years whether or not securitizations should be treated as off-balance-sheet sales, or kept on the balance sheet. Nevertheless, the concept, more commonly known as “mortgage backed securities,” has been around since the depression,

The unconsolidated subsidiary issue needs to be re-examined by the accounting profession. The basic accounting postulate of the accounting entity concept makes it very clear that the entire business entity should be reported, regardless of legal entity. The cook-book approach to rule making has lost sight of the postulate. As accounting reform unfolds, this area will most likely be fixed. 

There are also off-balance sheet assets that should be disclosed. For example, some finance companies have large balances of billed but uncollected late charges, which historically are collected. These items should be disclosed. Additionally, salvageable receivables written-off, but with a high likelihood of recovery, should also be disclosed.

The SEC’s new disclosure rules for off-balance-sheet arrangements, should add value to investors.

 

 

 

 

 

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