Reading Between the Lines

The Syndicate was ready for action. Six neighbors and I assembled in the “Gathering Room” of the condo complex before the first of the NFL playoff games last Saturday to consider our collective wagers on the four contests. To varying degrees we had researched the subject — seasonal wins and losses, injuries, rushing and passing records — and we had ready access to the Web for the more arcane stats that would provide the definitive Eureka insight. We were primed.

The issue, of course, was not just which team might win or lose but how to deal with the Spread, the determination by the Las Vegas betting house of the number of handicap points the perceived underdog would need in order to equalize the betting interest between the two teams. Without the Spread, there’s no action: the favorites do win the majority of the games. In fact, the higher-seeded team won all four times last weekend (though higher-seeded Denver was not the favorite versus Pittsburgh). But the Syndicate likes to think that the collective wisdom of its members will more often than not beat the Spread. With relatively little debate we reached consensus and, brimming with confidence, placed our bets. [Results below.]

So it is with financial analysts. Usually right, but never in doubt. However, while reliance on the numbers is fine for citing history, it’s much less certain for predictions or projections. I thought of the parallel as I read through the last three years of annual financial reports of a new client company which I signed up last week. The bound statements were the product of a CPA’s review and were supplemented by a spreadsheet which arrayed the three years of income statements and balance sheets side by side for ease of analysis. Not exactly bedtime reading, even for a numbers guy, but useful background, especially for a numbers guy.

However, having discussed the Company’s recent history for a couple of hours with the Owner, my goal in analyzing the statements was to determine not only if his story was confirmed, but if it was well-represented by the numbers. In a quick overview, I was looking for the following:

  • The Opinion: Were there any concerns expressed by the CPA in the cover letter which related to the integrity of the presentation?
  • The Content: Beyond the income statement, balance sheet, and statement of cash flow, was there a capitalization table reflecting investors’ interests? Were there notes explaining accounting policies, status of loans and leases, and unusual financial events?
  • The Format: Was the expense detail simply arrayed alphabetically by account, or was the analysis at a more sophisticated level, perhaps with the expenses grouped by type (e.g., Cost of Goods Sold, R & D, Sales and Marketing, General and Administrative)?
  • The Trends: What was the three-year Revenue history — up or down, by what percentage? To what extent did other income statement line items reflect the same percentage change? Was annual overhead expense increasing at the same rate as sales (usually not a good sign)?
  • Balance Sheet Trends: How has the cash position changed compared with short-term debt balances? Did accounts receivable and inventory balances track the changes in revenue? Are payables and accrued expenses showing disproportionate increases?
  • Cash Flow Insights: What’s been the source of the Company’s funding — internally from Operating Income, or from Debt or Equity infusions, or from Asset Sales? Has there been adequate renewal of the plant and equipment via Capital Asset purchases? What does a quick calculation of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) as a percentage of revenue reveal?
  • Additional Analysis: What does the calculator on my Smartphone (the 21st-century equivalent of the back of the envelope) provide in the way of a Current Ratio (current assets over current liabilities), a Debt-Equity Ratio, and a Debt Service Coverage Ratio (total annual debt service divided by EBITDA), and how do these compare with nominal industry standards? What does the interest rate being charged on the bank loans indicate about the company’s creditworthiness?

Fortunately, the Owner’s story was fully confirmed by the financial reports. The Company, a significant player in the local construction industry, has taken some heavy hits in recent years but has managed its retrenchment well with the continuing support of its financing sources. It is set to ride out the downturn and to come back strongly with lessons learned about effective management in the face of adversity.

Unfortunately, effective management in the face of adversity is now the challenge for the Syndicate. Had we been wagering on credit last weekend, we’d have been underwater. Despite a collective experience of 50+ years of professional football history and a full appreciation of the need to read between the lines (a/k/a the Spread) in understanding the story before placing our bets, we came out on the short end all four times. We were left wondering what kind of odds we might have been quoted on that happening (?!).