By Eleanor Bloxham, CEO of The Value Alliance

Banks are continuing to hemorrhage. "Banks are now losing money and going broke the old-fashioned way: They made loans that will never be repaid... Of the 77 failures in 2009, the F.D.I.C. could not even find a bank to acquire eight of them. Of the other 69, the agency signed loss-sharing agreements on 41." ("Most Failing Banks Are Doing It the Old-School Way", New York Times, Floyd Norris, August 20, 2009)

Similarly, some companies are continuing to face slow customer payment, especially smaller firms.  "Large corporations are tightening the screws on their smaller counterparts as the credit crunch intensifies companies' efforts to hold on to their cash. In an example of corporate Darwinism at work, the recent round of quarterly earnings results showed companies with annual revenue of more than $5 billion sped up their collection of cash from customers while slowing their own payments to suppliers. Firms with less than $500 million in annual sales, on the other hand, generally took longer to collect cash and paid their bills faster than in the same period a year ago, according to an analysis conducted for The Wall Street Journal by REL Consultancy." ("Big Firms are Quick to Collect, Slow to Pay", Wall Street Journal, Serena NG and Cari Tuna, August 31, 2009)

Of course, the principles of analysis 101 alert you to the fact that the prevailing climate and desperation in small firms, which large corporations are relying on to make their income statements and balance sheets look better, may not last. In the future, large firms may find themselves unable to count on changes in receivables' and payables' patterns to boost cash flow.  What the future holds for banks in this regulatory environment is a bit less clear, though certainly as business revives it is likely that smaller firms (and banks) will be able to improve their collections outlooks.

Fudging Credit Estimates To Create A Specific Earnings Bottom Line

Everyone understands that the current situation is a dramatic case. It does, however, point to a longer term lesson. In addition to looking at the trends in accounts receivable and accounts payable, which most practitioners will do, when you are analyzing an investment opportunity or making a decision to stay in or get out, you need to make a regular practice of unwinding the earnings numbers associated with a company's or bank's credit risk estimations. By doing this systematically, you not only can get a clearer view of the company on a current basis and an understanding of how forthright they may be, you can also more easily compare them with their peers, and better see the real trends in the numbers irrespective of the tendency of certain firms to fudge their credit estimations to create a specific earnings bottom line.

One easy way to begin your analysis is to simply review the firm's accruals for losses over time (for a bank these hit earnings in the line item provision for loan losses; in other companies, the accrual line is often called bad debt expense). Next, compare these figures to the cash write-off amounts contained in the footnotes (for a bank these are called net-charge offs; in other companies, the cash line is often termed write-offs or accounts receivable write-offs).

An Actual Company Example

Exhibits A - D below show an analysis of an actual firm and why a review of the credit risk disclosure is important.

Exhibit A shows the accrual loss estimates (the amounts that actually hit the earnings statement) versus the current cash write-offs for losses (shown in the company's footnotes).  For this firm, the increase in accruals versus the write-off amounts is dramatic in the second year.  This dramatic divergence in a particular year should send a red flag to any investor about the quality of reporting of the firm (and the job being performed by the auditors).  For this firm, the divergence in year five (in which the accruals are significantly lower than the write-offs) is also problematic. Combined, they suggest that the reported earnings for the firm should not be taken at face value. In fact, year two is likely to have been a much better year than the earnings would indicate, while year five is likely to have been a worse year than the reported earnings suggest.  (Exhibit D will demonstrate the impacts when we actually unwind the accrual numbers.)

For the same firm, Exhibit B shows the wild changes in the credit reserve accounts or allowance for doubtful accounts on the balance sheet which are a result of management's estimates. These increases and decreases are the estimates which directly influence the bottom line earnings results for this firm.  Taking a closer look, Exhibit C shows the wild swings in the estimates by quarter.  The erratic nature of the changing estimates should create alarms in your mind, as an investor, regarding a number of factors. These factors include the firm's financial reporting, the effectiveness of the external auditors, the impacts of such swings on earnings, and the likely misperceptions of other investors or analysts who have not performed this analysis in depth.

Given that the fudging of these accounts is possible, it is important, then, in understanding the magnitude of the impacts on reported earnings for this company, to reverse the impacts of the accruals and unwind them from the reported earnings numbers. Exhibit D shows the result of adding back to earnings the changes to the credit reserve accounts as a result of management's estimates. The exhibit compares the originally reported earnings to "adjusted earnings", which is the reported earnings with the credit reserve increases and decreases added back. Reversing the accruals shows that impacts in years two and five would, in fact, be significant from a reporting standpoint. The downward trend in the final year not visible in the reported results becomes clearer by unwinding the reported numbers.

In comparing investment in one firm to investments in others, you will want to make the same inquires and adjustments to look into the results for all of the firms under analysis. Doing so will give you a much better idea of how each bank or company is performing -- and allow you to make your own reasonable estimates of the impacts of credit on the particular companies. This allows you to form your own view, rather than simply accepting the management estimates and reporting.

If you have any questions on this topic or if there are other topics you'd like addressed in future articles, please email me at ebloxham@thevaluealliance.com.

Copyright 2009. The Value Alliance Company.  All rights reserved.