Archive for March, 2007

Excerpt from Reminiscences of a Stock Operator

The following is an excerpt from Jesse Livermore’s “Reminiscensces of a Stock Operator,” which is available in our public domain library.

It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.

I have heard of people who amuse themselves conducting imaginary operations in the stock market to prove with imaginary dollars how right they are. Sometimes these ghost gamblers make millions. It is very easy to be a plunger that way. It is like the old story of the man who was going to fight a duel the next day.

His second asked him, “Are you a good shot?”

“Well,” said the duelist, “I can snap the stem of a wineglass at twenty paces,” and he looked modest.

“That’s all very well,” said the unimpressed second. “But can you snap the stem of the wineglass while the wineglass is pointing a loaded pistol straight at your heart?”

With me I must back my opinions with my money. My losses have taught me that I must not begin to advance until I am sure I shall not have to retreat. But if I cannot advance I do not move at all. I do not mean by this that a man should not limit his losses when he is wrong. He should. But that should not breed indecision. All my life I have made mistakes, but in losing money I have gained experience and accumulated a lot of valuable don’ts. I have been flat broke several times, but my loss has never been a total loss. Otherwise, I wouldn’t be here now. I always knew I would have another chance and that I would not make the same mistake a second time. I believed in myself.

A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip. I am depending on him. Suppose Smith is away on a holiday when the selling time comes around? No, sir, nobody can make big money on what someone else tells him to do. I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment. It took me five years to learn to play the game intelligently enough to make big money when I was right.

Posted on 31st March 2007
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Bad Debt and the Allowance for Doubtful Accounts

Companies have a fair amount of discretion regarding how they will estimate their losses from customers who fail to pay, and when they will recognize the losses. This article, originally published at Stock Market Beat and reprinted here with the author’s permission, offers a nuts-and-bolts explanation of how investors can make any necessary adjustments. Another article at Stock Market Beat explains why this is important.

When a company records a sale, if it has not yet collected the proceeds it records an account receivable on the balance sheet. Sometimes the company is unable to collect its receivables, and they have to be written off as a bad debt expense. To prepare for this contingency, companies create a reserve account known as the allowance for doubtful accounts, where they estimate how much of their receivables will not be collected and exclude that amount from being recognized on the income statement. If in fact the receivable is not collected it is charged against the reserve account rather than appearing on the income statement at that time. Because the amount reserved in any period is subject to management’s discretion, it is an area that can be used to manipulate earnings. Even when management is completely scrupulous the allowance for doubtful accounts can be an early warning indicator for potential problems.

As noted above, management has some discretion as to how much of a reserve should be taken in a given accounting period. We have discussed similar issues with respect to financial receivables for companies that lease or finance sales to customers. We have also commented in several posts about companies that may be under-reserving their allowance for doubtful accounts. Here we explain how to analyze this account more fully.

Management’s discretion has certain limitations. The amounts recorded in reserve accounts has to be explained to auditors, and generally follow some guidelines. Sometimes it can be a simple percentage of sales or gross accounts receivable that is assumed will not be collected based on prior history. Sometimes the system may be more complicated, as described in the disclosures below, which were taken from Fidelity National Information System’s (FIS) recent 10Q:

Since the Merger with Certegy, the Company recognizes a reserve for estimated losses related to its card issuing business based on historical experience and other relevant factors. The Company records estimates to accrue for losses resulting from transaction processing errors by utilizing a number of systems and procedures in order to minimize such transaction processing errors. Card processing loss reserves are primarily determined by performing a historical analysis of loss experience and considering other factors that could affect that experience in the future. Such factors include the general economy and the credit quality of customers. Once these factors are considered, the Company assesses the reserve adequacy by comparing the recorded reserve to the estimated amount based on an analysis of the current trend changes or specific anticipated future events. Any adjustments are charged to costs of services. These card processing loss reserve amounts are subject to risk that actual losses may be greater than estimates.

In the Company’s check guarantee business, if a guaranteed check presented to a merchant customer is dishonored by the check writer’s bank, the Company reimburses the merchant customer for the check’s face value and pursues collection of the amount from the delinquent check writer. Loss reserves and anticipated recoveries are primarily determined by performing a historical analysis of our check loss and recovery experience and considering other factors that could affect that experience in the future. Such factors include the general economy, the overall industry mix of customer volumes, statistical analysis of check fraud trends within customer volumes, and the quality of returned checks. Once these factors are considered, the Company establishes a rate for check losses that is calculated by dividing the expected check losses by dollar volume processed and a rate for anticipated recoveries that is calculated by dividing the anticipated recoveries by the total amount of related check losses. These rates are then applied against the dollar volume processed and check losses, respectively, each month and charged to cost of revenue. The estimated check returns and recovery amounts are subject to risk that actual amounts returned and recovered may be different than the Company’s estimates.

However, even in these more complicated cases, the investor can compare the current allowance to past results based on a percentage of sales or receivables to gain insight as to trends. If the allowance is rising or falling at a significantly lower rate than sales it should tell the investor to take a closer look and figure out why.

When the amount being reserved is falling as a percentage of sales or receivables, the result is higher net income than there would have been using a consistent reserve percentage. It is easy to see how management might have an incentive to post higher earnings, so frequently this is the focus of investor concern. However, in the case of FIS we see the opposite trend: the allowance increased 51 per cent, compared with a 23 per cent increase in receivables. Sequential rise in sales cannot be determined due to the accounting treatment of the reverse acquisition of Certegy. The higher allowance for doubtful accounts in the period resulted in EPS being $0.02 lower than would have been reported had the allowance stayed at a consistent percentage of total accounts receivable.

There are several possible explanations for a significant increase in the allowance for doubtful accounts relative to sales or receivables:

  1. Something has changed. This may be the cause for the rise in FIS, as the company acquired Certegy in a reverse merger during the quarter. Certegy’s check guarantee business could very well have a higher incidence of uncollectible receivables than the legacy FIS business. (Note that this may not be a bad thing if the profitability is high enough to offset the higher incidence of bad debt.)
  2. The company is actually seeing higher than normal losses from uncollectible receivables. This is also possible in the case of FIS, as the allowance is set partially based on an estimate of current trends. Higher than normal levels of uncollectible receivables could be due to just random luck, but could also indicate the company is pursuing higher-risk customers. In the latter case, it would indicate a lower quality to recorded sales and earnings.
  3. The company is doing well and management wants to set aside reserves for a rainy day. This would be a case of earnings management in which the company has perhaps done better than expected and uses the opportunity to pad reserves in case they want to tap into them in a tougher period.
  4. The company is doing poorly and wants to take all its lumps and make future performance look better. This is known as taking a big bath. If the company has no chance to make expectations it may want to set aside extra reserves and take a bigger hit today in order to set up easier comparisons in the future. Since FIS has a number of restructuring and merger charges in the current period, as well as the new requirement to expense stock options, this is yet another possible explanation of the rise in the allowance for doubtful accounts.

Investors should call the company or otherwise try to figure out what is behind any large change in the allowance for doubtful accounts relative to sales and/or receivables.

Posted on 29th March 2007
Under: Adjusting Reported Financial Statements, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

Cash Flow from Financing Activities

The financing activities section is always presented in direct format. AT&T’s cash flow from financing activities section is reproduced below.


In 2006 AT&T increased its short-term borrowings by $3.6 billion and issued new long-term debt of $1.5 billion while repaying $4.2 billion in existing long-term debt. The total debt (other than that acquired when the company purchased other companies) increased by nearly $1 billion and shifted from longer-term to shorter maturities. Typically, investors will feel more comfortable with long-term debt than an equal amount of short-term debt because the earlier debt maturities can prevent some companies from having cash available for other activities. In AT&T’s case, however, with overall strong cash flows and ready access to credit markets this is unlikely to be a concern.

AT&T also used $2.7 billion of cash to repurchase shares, which were put into the treasury shares account. Some of these ($589 million) were reissued – probably (though not necessarily) through an incentive stock option program. Such programs contributed an $18 million tax benefit in 2006. In 2005, the company also repurchased preferred shares of a subsidiary.

The other major financing cash flow for AT&T was dividend payments to shareholders, which consumed $5.2 billion in cash in 2006. Altogether, cash transactions with investors (both credit and equity) consumed $6.1 billion of the company’s cash for the year. This means that the company returned more cash to investors than it took in. In 2004 the opposite was the case. AT&T needed more cash than it was able to generate through operations, and it raised that cash by issuing nearly $9 billion of net short-term and long-term debt.

Posted on 29th March 2007
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Cash Flow From Investing Activities

Cash flow from investing activities is always presented in direct format. AT&T’s cash flow from investing section is presented below.


The major investments made by AT&T in 2006 included $8.3 billion for capital expenditures. Much of this expense, for AT&T, was spent maintaining or replacing existing plant. For other companies, particularly younger companies, capital expenditures are often necessary to keep up with planned growth. Underinvestment in capital could lead to lost sales opportunities, while too much investment would be inefficient. A portion ($756 million) of the $8.3 billion was recovered through sales (dispositions) of assets, investments and businesses the company no longer needed. It also received $368 million more in cash from acquired firms than it spent in acquiring those firms. This is because the acquisitions were made using company stock rather than cash.

AT&T lists separately the money it spends buying short-term investments (held-to-maturity securities) and the proceeds it receives as these investments mature. In both cases the amount is relatively small compared to AT&T’s total cash flows. Alternatively, the company could list the net cash flow from purchases and maturities on a single line. AT&T’s cash flows from investing were negative in all three years. This is common, especially for growing firms.

Posted on 29th March 2007
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Reconciling Net Income to Cash Flow From Operations: Working Capital Adjustments

Companies that report cash flows using the direct method must reconcile changes in cash to net income. This reconciliation is equivalent to the indirect method of presentation. The reconciliation begins with net income from the income statement. The adjustments generally fall into two categories: non-cash adjustments and working capital adjustments.

Under the accrual method of accounting, expenses are matched with related revenues for timing purposes. In cases where income statement recognition differs from the timing of cash flows, the cash flow statement presents an associated working capital adjustment. Consider the working capital adjustments reported by AT&T:


Accounts receivable represent sales that have been made for which the cash has not yet been collected. Clearly this is not a cash flow, so increases (decreases) in accounts receivable result in a downward (upward) adjustment to cash flow from operations. In general, changes in asset accounts result in an opposite-direction cash flow adjustment, while changes in liability accounts result in a same-direction cash flow adjustment, as summarized below:


The working capital adjustments relate to changes in balance sheet accounts, while net income and non-cash adjustments are income statement accounts. The cash flow statement serves to tie the other two statements together.

Posted on 28th March 2007
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Reconciling Net Income to Cash Flow From Operations: Noncash Adjustments

Companies that report cash flows using the direct method must reconcile changes in cash to net income. This reconciliation is equivalent to the indirect method of presentation. The reconciliation begins with net income from the income statement. The adjustments generally fall into two categories: non-cash adjustments and working capital adjustments.

Noncash adjustments relate to expenses recorded on the income statement for which no cash was paid. The most common of these adjustments is for depreciation and amortization, but there can be many others. Consider the non-cash adjustments reported by AT&T:


In each of the three years presented, the non-cash expense related to depreciation and amortization was larger than net income. In addition, AT&T recorded seven other types of non-cash adjustments:

  1. Undistributed earnings from investments in equirt affiliates: AT&T accounted for its partial ownership of Cingular wireless using the equity method, under which it recorded a proportionate share of Cingular’s net income on its own income statement. However, it did not actually receive cash from Cingular (which used the funds for its own growth) so AT&T must deduct the net income associated with Cingular when reconciling net income to cash flow from operations.
  2. Provision for uncollectible accounts: AT&T estimates the portion of its accounts receivable that will not be paid and deducts the expected amount from net income. The estimate must be added back (and any actual bad debt expense will be deducted through working capital adjustments.)
  3. Amortization of investment tax credits: The reverse of fixed asset depreciation and amortization, the amortization of a liability must be deducted.
  4. Deferred income tax (benefit) expense: Any expense put off to another year is added back to net income, while delayed benefits must be subtracted.
  5. Net gains on sales of investments: such gains are not considered operating items, and instead are reported as adjustments to cash flows from investing activities.
  6. Income from discontinued operations can no longer be considered an operating cash flow.
  7. Retirement benefit funding: Companies report a smoothed amount on the income statemtent related to the expenses associated with funding retirement plans for employees. The cash flow statement requires all contributions to be reported as cash flows in the associated year.

Posted on 28th March 2007
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Proxy Battles: A Motorola Case Study

Motorola (MOT) had the usual start to its recently filed Proxy statement:

Dear fellow stockholder:

You are cordially invited to attend Motorola’s 2007 Annual Stockholders Meeting. The meeting will be held on Monday, May 7, 2007 at 4:30 p.m., local time, in the Rubloff Auditorium at The Art Institute of Chicago, 230 South Columbus Drive, Chicago, Illinois 60603.

At this year’s Annual Meeting, in addition to electing your entire 11 member board, we are asking stockholders to approve an amendment to the Motorola Employee Stock Purchase Plan of 1999 (the “MOTshare Plan”) to make 50 million additional shares available for purchase by employees. The MOTshare Plan encourages employees to own more shares of Motorola and thereby further aligns their interests with those of all Motorola stockholders.

I encourage each of you to vote your shares through one of the three convenient methods described in the enclosed Proxy Statement, and if your schedule permits, to attend the meeting. I would appreciate your support of the nominated directors and the proposed amendment to the MOTshare Plan. Your vote is important, so please act at your first opportunity.

On behalf of your Board of Directors, thank you for your continued support of Motorola.

The problem (for Motorola) is that there has been another proxy statement filed, this one by dissident shareholder Carl Icahn. Icahn has some different ideas as to how the shareholders should vote on the matters before them. Let’s take a look at each one.

The candidates nominated by the company as directors include the 10 current directors and David Dorman, retired chairman of AT&T. Icahn has nominated himself. Those 11 receiving the most votes will win, and only those votes cast in favor of a candidate will be counted.

According to Motorola’s filing, the compensation of directors is fairly favorable, though the company is large and it is unlikely any of the nominees “needs” the money.

During 2006, the annual retainer fee paid to each non-employee director was $100,000. In addition, (1) the chairs of the Audit and Legal and Compensation and Leadership Committees each received an additional annual fee of $15,000, (2) the chairs of the other committees each received an additional annual fee of $10,000, and (3) the members of the Audit and Legal Committee, other than the chair, each received an additional annual fee of $5,000. The Company also reimburses its directors, and in certain circumstances spouses who accompany directors, for travel, lodging and related expenses they incur in attending Board and committee meetings.

Including stock and other awards, most of the directors took home about a quarter-million dollars in 2006.

The next proposal is to increase the shares authorized for issuance as employee compensation:

The Board of Directors believes it is in the best interests of the Company to encourage stock ownership by employees of the Company. Accordingly, the Motorola Employee Stock Purchase Plan of 1999 (the “MOTshare Plan” or the “Plan”) was initially adopted in 1999 and authorized the sale to employees of up to an aggregate of 54.3 million shares of Common Stock issued under the Plan. In 2002, both the Board of Directors and the stockholders approved amending the Plan to increase the aggregate number of shares of Common Stock available for sale to employees by 50 million shares.

Having already approved the plan, the Board recommends voting in favor, while Icahn’s proxy makes no recommendation.

Proposal #3 would require a shareholder vote on management compensation plans. The Board does not like this plan, Icahn’s group does.

Proposal #4 seeks to amend the bylaws so that incentive compensation earned by managers could be taken back if it was later determined that the appropriate targets were not met. The Board opposes, and Icahn’s group has no opinion on the matter.

Posted on 27th March 2007
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Cash Flow Statement – The Indirect Method

While expressing the preference for the direct method, U.S. GAAP and IAS also include the requirement that when the direct method is presented on the face of the cash flow statement, the notes to the statement must include a reconciliation of accrual accounting net income to cash from operating activities. This reconciliation constitutes the indirect method format. A cash flow statement, using the indirect method, is presented below.


This indirect format links the cash from operating activities to the accrual accounting income statement results, clarifying the distinction between the two. The income statement reflects the operations of the firm, measured on the accrual basis, rather than on a cash basis. Most of the items in an income statement are related to operating activities as defined by the cash flow statement rules. Therefore, it is possible to reconcile the net income from the income statement to the cash from operating activities. This is accomplished by removing the effects of items that appear on the income statement but do not affect cash such as depreciation and amortization expense, items where the timing between accrual and cash is different (e.g., changes in accounts receivable, accounts payable, prepaids) as well as a few items that appear on the income statement but are not categorized as operating activities for cash flow purposes (e.g., gains or losses from sale of PP&E—remember, cash flows from sale of PP&E are included in the investing activities section)

Companies can choose to do one of the following:

• Report the cash flow statement under the direct method, with an indirect reconciliation provided as supplementary information.
• Report the cash flow statement under the indirect method.

Understandably, most firms opt to create only one format, the indirect method, and present it on the face of the cash flow statement. Only rarely does a firm provide the direct method format.

Posted on 26th March 2007
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Cash Flow Statement – The Direct Method

The cash flow statement summarizes all activity in the cash accounts of the corporation. The statement user can imagine that, if one had access to the bank statements for the year, the cash flow statement could be created by sorting all transactions and summarizing them into categories. The checks would be sorted by what type of bill was being paid, the deposits would be sorted by the source of the inflow, and the resulting statement would create a cash flow statement in what is called the direct method format. This is the format presented below.


In the direct method format, each line of the operating activities section represents a sum of all checks or deposits in a particular category. For example, the operating activities section would include such items as cash received from customers; cash paid to suppliers; cash paid for interest; cash paid for wages; cash paid for research and development; cash paid for selling, general, and administrative costs; and any other relevant summary lines.

The investing activities section would include such items as cash paid for acquiring capital assets and cash received from disposals of the same classes of assets. Also included in this section would be the cash paid to invest in the stock of another firm, as well as the proceeds from the subsequent sale of the stock.

The financing activities section would include cash received from stockholders’ investing in the firm and any cash returned to stockholders, whether in the form of stock repurchases or dividends paid. The liability component of financing activities would include cash received from debt holders who have loaned money to the firm during the period and any principal payments made by the firm back to those debt holders.

Both U.S. GAAP and IAS encourage companies to present operating cash flows using the direct-method format, but another format, the indirect method, is also available. The direct format would provide the summarized detail from the cash account, as described above, corresponding to deposits made and checks written. The items in this intuitive format are straightforward and easy for the analyst to understand. In fact, under both IAS and U.S. GAAP, the financing and investing activities sections are presented in just this manner.

Posted on 26th March 2007
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Cash Flows from Financing Activities

Cash flows from financing activities are those that take place between a firm and its investors. These include both the equity investments of stockholders (owners) and the loans from bondholders and other creditors. When the company issues new shares or debt in exchange for cash it records a cash inflow from financing, and when it repurchases shares, pays dividends (with some exceptions under IAS) or pays off debt it records a cash outflow. This section of the cash flow statement is typically related to activities in the non-current liabilities and owners’ equity section of the balance sheet. Under IAS, cash interest payments may also be included here.

Posted on 26th March 2007
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