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the capital structure changes. That is, FCFE will go up if the company replaces debt
with equity (an action that reduces interest paid and therefore increases CFO) and
vice versa. This problem can be overcome by using free cash flow to firm (FCFF),
which is not distorted by the ratio of debt to equity.



Earnings

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. The diagram below traces selected
cash flows from operations and investing to their counterparts on the income
statement (cash flow from financing (CFF) does not generally map to the income
statement):




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Many cash flow items have a direct counterpart, that is, an accrual item on the
income statement. During a reporting period like a fiscal year or a fiscal quarter, the
cash flow typically will not match its accrual counterpart. For example, cash spent
during the year to acquire new inventory will not match cost of goods sold (COGS).
This is because accrual accounting gives rise to timing differences in the short run:
on the income statement, revenues count when they are earned, and they're
matched against expenses as the expenses are incurred.

Expenses on the income statement are meant to represent costs incurred during the
period that can be tracked either (1) to cash already spent in a prior period or (2) to
cash that probably will be spent in a future period. Similarly, revenues are meant to
recognize cash that is earned in the current period but either (1) has already been
received or (2) probably will be received in the future. Although cash flows and
accruals will disagree in the short run, they should converge in the long run, at least
in theory.

Consider two examples:

• Depreciation - Say a company invests $10 million to buy a manufacturing
plant, triggering a $10 million cash outflow in the year of purchase. If the life
of the plant is 10 years, the $10 million is divided over each of the
subsequent 10 years, producing a non-cash depreciation expense each year
in order to recognize the cost of the asset over its useful life. But
cumulatively, the sum of the depreciation expense ($1 million per year x 10
years) equals the initial cash outlay.



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• Interest Expense - Say a company issues a zero-coupon corporate bond,
raising $7 million with the obligation to repay $10 million in five years. During
each of the five interim years, there will be an annual interest expense but no
corresponding cash outlay. However, by the end of the fifth year, the
cumulative interest expense will equal $3 million ($10 million - $7 million),
and the cumulative net financing cash outflow will also be $3 million.

In theory, accrual accounting ought to be superior to cash flows in gauging operating
performance over a reporting period. However, accruals must make estimations and
assumptions, which introduce the possibility of flaws.

The primary goal when analyzing an income statement is to capture normalized
earnings--that is, earnings that are both recurring and operational in nature. Trying
to capture normalized earnings presents two major kinds of challenges: timing issues
and classification choices. Timing issues cause temporary distortions in reported
profits. Classification choices require us to remove one-time items or earnings not
generated by ongoing operations, such as gains from pension plan investments.

Timing Issues
Most timing issues fall into four major categories:




Premature revenue recognition and delayed expenses are more intuitive than the


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distortions caused by the balance sheet, such as overvalued assets. Overvalued
assets are considered a timing issue here because, in most (but not all) cases, "the
bill eventually comes due." For example, in the case of overvalued assets, a
company might keep depreciation expense low by carrying a long-term asset at an
inflated net book value (where net book value equals gross asset minus accumulated
depreciation), but eventually the company will be required to "impair" or write-down
the asset, which creates an earnings charge. In this case, the company has managed
to keep early period expenses low by effectively pushing them into future periods.

It is important to be alert to earnings that are temporarily too high or even too low
due to timing issues.

Classification Choices
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.

We will use Sprint's latest income statement to answer the question concerning the
issue of classification.




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We identified five key lines from Sprint's income statement. (The generic label for
the same line is in parentheses):

1. Operating Income before Depreciation and Amortization (EBITDA)
Sprint does not show EBITDA directly, so we must add "depreciation and
amortization" to operating income (EBIT). Some people use EBITDA as a
proxy for cash flow--as depreciation and amortization are non-cash charges--
but EBITDA does not equal cash flow because it does not include changes to
working capital accounts. For example, EBITDA would not capture the
increase in cash if accounts receivable were to be collected.

The virtue of EBITDA is that it tries to capture operating performance--that is,
profits after cost of goods sold (COGS) and operating expenses, but before
non operating items and financing items such as interest expense. However,
there are two potential problems. First, not necessarily everything in EBITDA
is operating and recurring. Notice that Sprint's EBITDA includes an expense of
$1.951 billion for "restructuring and asset impairments." Sprint surely
includes the expense item here to be conservative, but if we look at the
footnote, we can see that much of this expense is related to employee
terminations. Since we do not expect massive terminations to recur on a
regular basis, we could safely exclude this expense.




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Second, EBITDA has the same flaw as operating cash flow (OCF), which we
discussed in this tutorial's section on cash flow: there is no subtraction for
long-term investments, including the purchase of companies (since goodwill is
a charge for capital employed to make an acquisition). Put another way, OCF
totally omits the company's use of investment capital. A company, for
example, can boost EBITDA merely by purchasing another company.

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.

Furthermore, EBIT does not include interest expense and therefore is not
distorted by capital structure changes. That is, it will not be affected merely
because a company substitutes debt for equity or vice versa. By the same
token, however, EBIT does not reflect the earnings that accrue to
shareholders since it must first fund the lenders and the government.

As with EBITDA, the key task is to check that recurring, operating items are
included and items that are either non-operating or non-recurring are
excluded.

3. Income from Continuing Operations before Taxes (Pre-tax Earnings)
Pre-tax earnings subtracts (includes) interest expense. Further, it includes
other items that technically fall within "income from continuing operations,"
which is an important technical concept.

Sprint's presentation conforms to accounting rules: items that fall within
income from continuing operations are presented on a pre-tax basis (above
the income tax line), whereas items not deemed part of continuing operations
are shown below the tax expense and on a net tax basis.

The thing to keep in mind is that you want to double-check these
classifications. We really want to capture recurring, operating income, so
income from continuing operations is a good start. In Sprint's case, the
company sold an entire publishing division for an after-tax gain of $1.324
billion (see line "discontinued operations, net"). Amazingly, this sale turned a
$623 million loss under income from continuing operations before taxes into a
$1.2+ billion gain under net income. Since this gain will not recur, it is
correctly classified.

On the other hand, notice that income from continuing operations includes a
line for the "discount (premium) on the early retirement of debt." This is a
common item, and it occurs here because Sprint refinanced some debt and
recorded a loss. But, in substance, it is not expected to recur and therefore it

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should be excluded.

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.

5. Net Income
Compared to income from continuing operations, net income has three
additional items that contribute to it: extraordinary items, discontinued
operations, and accounting changes. They are all presented net of tax. You
can see two of these on Sprint's income statement: "discontinued operations"
and the "cumulative effect of accounting changes" are both shown net of
taxes--after the income tax expense (benefit) line.

You should check to see if you disagree with the company's classification,
particularly concerning extraordinary items. Extraordinary items are deemed
to be both "unusual and infrequent" in nature. However, if the item is deemed
to be either "unusual" or "infrequent," it will instead be classified under
income from continuing operations.

Summary
In theory, the idea behind accrual accounting should make reported profits superior
to cash flow as a gauge of operating performance. But in practice, timing issues and
classification choices can paint a profit picture that is not sustainable. Our goal is to
capture normalized earnings generated by ongoing operations.

To do that, we must be alert to timing issues that temporarily inflate (or deflate)
reported profits. Furthermore, we should exclude items that are not recurring,
resulting from either one-time events or some activity other than business
operations. Income from continuing operations--either pre-tax or after-tax--is a good
place to start. For gauging operating performance, it is a better starting place than
net income, because net income often includes several non-recurring items such as
discontinued operations, accounting changes, and extraordinary items (which are
both unusual and infrequent).

We should be alert to items that are technically classified under income from
continuing operations but perhaps should be manually excluded. This may include
investment gains and losses, items deemed either "unusual" or "infrequent," and
other one-time transactions such as the early retirement of debt.



Revenue

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

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