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problems. year incentives.
If free cash flow to equity (FCFE) (which equals In the long-run, it is unlikely that
cash flow from operations minus cash flow from divergence between the two can be
investments) is growing more than earnings, it sustained--eventually, earnings will
may be a good sign. (Conversely, a FCFE that probably converge with the cash flow
grows less than earnings may be a bad sign.) trend.
The funded status of a pension plan, which Unless trends reverse, under-funded
equals the fair value of plan assets minus the (over-funded) pension plans will
projected benefit obligation (PBO), tends to require greater (fewer) contributions
impact future earnings. 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-recurring gains - These include gains due to the sale of a business, 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. Gains due to financing - These are important because, while they are real
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. In the income statement: Conservative revenue recognition is shown by
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. In the balance sheet: Conservative reporting practices include sufficient cash
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


This tutorial can be found at: http://www.investopedia.com/university/financialstatements/
(Page 65 of 66)
Copyright © 2004, Investopedia.com - All rights reserved.
Investopedia.com “ the resource for investing and personal finance education.


statements don't have to sort through multiple layers of common stock,
preferred stock, and several complex debt instruments; and a debt burden
that is manageable in size, not overly exposed to interest rate changes, and
not overly burdened with covenants that jeopardize the common
shareholders.

Final Note
This series is designed to help you spot red and green flags in your potential stock
investments. Keep in mind the limitations of financial statements: they are
backward-looking by definition, and you almost never want to dwell on a single
statistic or metric.

Finally, U.S. accounting rules are always in flux. At any given time, the Financial
Accounting Standards Board (FASB) is working on several accounting projects. You
can see the status of the projects at their website. But even as rules change and
tighten in their application, companies will continue to have plenty of choices in their
accounting. So, if there is a single point to this tutorial, it is that you should not
accept a single number, such as basic or diluted earnings per share (EPS), without
looking "under the hood" at its constituent elements.

Related Tutorials:


Accounting and Valuing ESOs - Learn the different accounting and valuation
treatments of ESOs, and discover the best ways to incorporate these techniques into
your analysis of stock.


Introduction to Fundamental Analysis - Here's an easy-to-understand
tutorial on the techniques of analyzing a company's financial statements, including
the annual and quarterly reports, the auditor's report, and much more.


Guide to Stock Picking Strategies - Every stock investor needs a strategy that
fits his or her outlook and style. Here you will learn abut the most popular stock
picking strategies, including their philosophies, methods, and tools.


Advanced Bond Concepts - This detailed tutorial explains some of the more
complex concepts and calculations you need to know for trading bonds, including
bond pricing, yield, term structure of interest rates, duration, and much more.




This tutorial can be found at: http://www.investopedia.com/university/financialstatements/
(Page 66 of 66)
Copyright © 2004, Investopedia.com - All rights reserved.
Economic Value Added - EVA




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Economic Value Added - EVA
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http://www.investopedia.com/terms/e/eva.asp02/02/2005 23:30:15
Balance Sheet




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Balance Sheet
Term of the Day
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Articles A company's financial statement. It reports the Assets
company's assets, liabilities and net worth at a
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Clean Balance
specific time.
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You will notice that assets = liabilities +
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shareholder equity. This equation is true for all Income Statement
Corporate balance sheets. If the balance sheet is
"consolidated" it just means that the company Inventory
is a corporate group rather than a single
Liability
company.
Other Current
Assets

Other Long-Term
Liabilities
Reading the Balance Sheet - Learn about the components
Shareholder's
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