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dangerous sign of collections problems? Let's take a look at the footnote:

We were party to an agreement, as amended, under which we sold a defined pool of
our accounts receivable, on a revolving basis, through a special-purpose, wholly
owned subsidiary, which then sold an undivided interest in the receivables to a third
party.... This agreement terminated on its scheduled expiration date of March 31,
2003. As a result, on April 2, 2003, we paid $250 million, which represented the total
amount owed to the third party by the subsidiary, and subsequently collected the
related receivables. (Note 8, Delta 10K FY 2003)

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Here's the translation: during 2002, most of Delta's receivables were factored in an
off-balance sheet transaction. By factored, we mean Delta sold some of its accounts
receivables to another company (via a subsidiary) in exchange for cash. In brief,
Delta gets paid quickly rather than having to wait for customers to pay. However,
the seller (Delta in this case) typically retains some or all of the credit risk--the risk
that customers will not pay. For example, they may collateralize the receivables.

We see that during 2003, the factored receivables were put back onto the balance
sheet. In economic terms, they never really left but sort of disappeared in 2002. So,
the 2003 number is generally okay, but there was not a dramatic jump. More
importantly, if we were to analyze year 2002, we'd have to be sure to manually
"add-back" the off-balance sheet receivables, which would otherwise look artificially
favorable for that year.

We also highlighted Delta's increase in "Prepaid expenses and other" because this
innocent-looking account contains the fair value of Delta's fuel hedge derivatives.
Here's what the footnote says:

Prepaid expenses and other current assets increased by 34%, or $120 million,
primarily due to an increase in prepaid aircraft fuel as well as an increase in the fair
value of our fuel hedge derivative contracts.... Approximately 65%, 56% and 58% of
our aircraft fuel requirements were hedged during 2003, 2002 and 2001,
respectively. In February 2004, we settled all of our fuel hedge contracts prior to
their scheduled settlement dates¦ and none of our projected aircraft fuel
requirements for 2005 or thereafter.

The rules concerning derivatives are complex, but the idea is this: it is entirely likely
that working capital accounts contain embedded derivative instruments. In fact, the
basic rule is that, if a derivative is a hedge whose purpose is to mitigate risk (as
opposed to a hedge whose purpose is to speculate), then the value of the hedge will
impact the carrying value of the hedged asset. For example, if fuel oil is an inventory
item for Delta, then derivatives contracts meant to lock-in future fuel oil costs will
directly impact the inventory balance. Most derivatives, in fact, are not used to
speculate but rather to mitigate risks that the company cannot control.

Delta's footnote above has good news and bad news. The good news is that, as fuel
prices rose, the company made some money on its fuel hedges, which in turn offset
the increase in fuel prices--the whole point of their design! But this is overshadowed
by news which is entirely bad: Delta settled "all of [their] fuel hedge contracts" and
has no hedges in place for 2005 and thereafter! Delta is thus exposed in the case of
high fuel prices, which is a serious risk factor for the stock.

Traditional analysis of working capital is defensive; it asks, "Can the company meet
its short-term cash obligations?" But working capital accounts also tell you about the
operational efficiency of the company. The length of the cash conversion cycle
(DSO+DIO-DPO) tells you how much working capital is tied up in ongoing
operations. And trends in each of the days-outstanding numbers may foretell
improvements or declines in the health of the business.

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Investors should check the inventory costing method, and LIFO is generally preferred
to FIFO. However, if the LIFO reserve drops precipitously year over year, then the
implied inventory liquidation distorts COGS and probably renders the reported profit
margin unusable.

Finally, it's wise to check the current accounts for derivatives (or the lack of them,
when key risks exist) and off-balance sheet financing.

Long-Lived Assets

In the preceding section, we examined working capital, which refers to the current
assets and liabilities of a company. In this section, we take a closer look at the long-
lived assets (a.k.a. non-current assets) carried on the balance sheet. Long-lived
assets are those that provide the company with a future economic benefit beyond
the current year or operating period. It may be helpful to remember that most (but
not all) long-lived assets start as some sort of purchase by the company.

In fact, whenever a company purchases an asset, it will either expense or capitalize
the purchase. Consider a simple example of a company that generates $150 in sales
and, in the same year, spends $100 on research and development (R&D). In
scenario A below, the entire $100 is expensed and, as a result, the profit is simply
$50 ($100 “ $50). In scenario B, the company capitalizes the $100, which means a
long-lived asset is created on the balance sheet and the cost is allocated (charged)
as an expense over future periods. If we assume the asset has a five-year life, only
one-fifth of the investment is allocated in the first year. The other $80 remains on
the balance sheet, to be allocated as an expense over the subsequent four years.
Therefore, the profits are higher under scenario B, although the cash flows in the two
scenarios are exactly the same:

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There are various technical terms for the allocation of capitalized assets, but each
refers to the pattern in which the assets' prices are allocated to future period
expenses: depreciation is the allocation of plant, property, and equipment;
amortization is the allocation of goodwill; and depletion is the allocation of natural
resource assets, such as oil wells.

The typical long-lived area of the balance sheet includes the following accounts:

Depreciation is tricky because it is the allocation of a prior capital expenditure to an
annual expense. Reported profits are directly impacted by the depreciation method.
And because depreciation is a non-cash expense charge, some analysts prefer cash

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flow measures or EBITDA, which is a measure of earnings before the subtraction of
depreciation. However, depreciation typically cannot be ignored because it serves a
valuable purpose: it sets aside an annual amount (a sinking fund, if you will) for the
maintenance and replacement of fixed assets.

Because depreciation is an accounting convention, you sometimes see an alternative
label: "economic depreciation." This is an adjusted depreciation that represents the
"true" amount that a company needs to allocate annually in order to maintain and
replace its fixed asset base. In theory, economic depreciation corrects for errors in
both directions. Consider the depreciation of real estate, which is usually an over-
charge, reducing the real estate's book value--calculated by the original investment
minus accumulated depreciation--to something far below its fair market value. On
the other hand, consider a key piece of equipment that is subject to rapid inflation.
Its eventual replacement will cost more than the original, in which case depreciation
actually under-charges the expense. If depreciation expense is large relative to other
expenses, it often helps to ask whether the charge approximates the replacement
value of the assets. Determining this can be difficult, but sometimes the footnotes in
a company's financial documents give explicit clues about future expenditures.

It is also helpful to look at the underlying trend in the fixed asset base. This will tell
you whether the company is increasing or decreasing its investment in its fixed asset
base. An interesting side effect of decreasing investments in the fixed asset is that it
can temporarily boost reported profits. Consider the non-current portion of
Motorola's balance sheet:

You can see that the book value of Motorola's plant, property, and equipment (PP&E)
fell roughly a billion dollars to $5.164 billion in 2003. We can understand this better
by examining two footnotes, which are collected below:

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The book value is the gross investment (that is, the original or historical purchase
price) minus the accumulated depreciation expense. Book value is also called net
value, meaning 'net of depreciation'. In Motorola's case, the gross asset value is
dropping (which indicates asset dispositions) and so is the book value. Motorola has
disposed of assets without a commensurate investment in new assets. Put another
way, Motorola's asset base is aging.

Notice the effect on depreciation expense: it drops significantly, from $2 billion to
$1.5 billion in 2003. In Motorola's case, depreciation is buried in cost of goods sold
(COGS), but the temporary impact is a direct boost in pre-tax profits of half a billion
dollars. To summarize, an aging asset base--the result of the company disposing of
some old assets but not buying new ones--can temporarily boost profits. When
assets are aged to inflate reported profits, it is sometimes called "harvesting the

We can directly estimate the age of the fixed asset base with two measures: average
age in percentage terms and average age in years. Average age in percentage
equals accumulated depreciation divided by the gross investment. It represents the
proportion of the assets that have been depreciated: the closer to 100%, the older
the asset base. Average age in years equals accumulated depreciation divided by the
annual depreciation expense. It is a rough estimate of the age of the in-place asset
base. Below, we calculated each for Motorola. As you can see, these measures show
that the asset base is aging.

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There are various methods to account for corporate investments, and often
management has some discretion in selecting a method. When one company (a
parent company) controls more than 50% of the shares of another company (a
subsidiary), the subsidiary's accounts are consolidated into the parent's. When the
control is less than 50%, there are three basic methods for carrying the value of an
investment: these are the cost, market, and equity methods. We show each method
below. But first, keep in mind there are three sorts of investment returns:

1. The investment can appreciate (or depreciate) in market value: we call these
holding gains or losses.

2. The investment can generate earnings that are not currently distributed to
the parent (they are instead retained): we call this investment income.

3. The investment can distribute some of its income as cash dividends to the

The table below explains the three methods of accounting for corporate investments
that are less than 50% owned by the parent:

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When an investment pays cash dividends, the rules are straightforward: they will be
recognized on the parent company's income statement. But the rules are not
straightforward for (i) undistributed earnings and (ii) gains/losses in the investment's
holding value. In both cases, the parent may or may not recognize the

We have at least three goals when examining the investment accounts. First, we
want to see if the accounting treatment has hidden some underlying economic gain
or loss. For example, if a company uses the cost method on a superior investment
that doesn't pay dividends, the investment gains will eventually pay off in a future
period. Our second goal is to ask whether investment gains/losses are recurring.
Because they are usually not operating assets of the business, we may want to
consider them separately from a valuation of the business. The third goal is to gain
valuable clues about the company's business strategy by looking at its investments.
More often than not, such investments are not solely motivated by financial returns.
They are often strategic investments made in current/future business partners.
Interesting examples include investments essentially made to outsource research


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