If you've never been to this site before, start with the first post, titled: "Building Wealth the Real Way"

Saturday, March 7, 2009

Security Analysis:Chapter 16

Now we will deal with balance sheet analysis.

For cash items, the analyst should include everything equivalent to cash; the analyst should include all the cash equivalents the company lists and any equivalent which is not shown as current but could be if the company decided to. Cash-surrender value of life-insurance policies are generally shown as an intermediate item, but the analyst may include them as part of current assets for the purpose of certain calculations, such as finding the current asset value of the stock.

For inventories, valuation is the most important factor, especially pertaining to the FIFO and LIFO methods, as discussed in Chapter 11.

Receivables should be shown as current assets, even if the period of repayment extends well over a year. Some companies sell the receivables to finance companies or banks under the condition that the company is responsible for nonpayment. These amounts should be added to both receivables and current liabilities.
When receivables play a large part of the company's business, extra attention is needed to make sure that the reserve for losses and collection expense is enough; comparisons should be made with other companies in the same field.
Some companies set up reserves for income tax to be paid upon collection of the receivables, but the analyst should subtract these directly from the receivables to make a more accurate figure.

Any reserves which represent a fairly definite liability should be considered by the analyst as current liabilities. Current liabilities should be all liabilities due within a year.

Intermediate assets include non-current receivables, investments not treated as marketable securities, cash-surrender value of life insurance, and deferred assets. Most companies include claims for tax refunds, but some show this as a current receivable.

Fixed assets, also known as the plant account and property account, is carried usually at actual cost minus depreciation.

Prepaid Expenses and Deferred Charges are sometimes confused. A prepaid expense is an expense paid in advance which has actual value, like paying 12 months of rent at the beginning of the year. Each month, this prepaid expense will be deducted by 1/12th. A deferred charge is very similar, but has no substance. For instance, 100 thousand dollars may be spent to start a company, but, instead of charging the full 100 thousand at once, it could be called a deferred charge, and amortized over a period of time.
Large prepaid expenses/deferred charges must be examined closely, but, usually prepaid expenses/deferred charges are too small to matter and can be ignored.

Bond discounts are when a company sells a bond and receives less than par value for them. The discount can be charged off against surplus or carried as an asset and be amortized over the life of the bond. Usually, these items are too small to matter much.

Intangible assets include good-will, patents, copyrights, trade-marks, franchises and licenses, organization and development expenses, etc.

Leaseholds - the right to occupy a premises for a stated period of time subject to payment of rent. It may be considered an asset if the rent is well below current-rental value of the property, but it is intangible.


The analyst is concerned with two main things when dealing with liabilities: the treatment of reserve items and the proper valuation of the preferred-stock liability. We have already gone over the treatment of reserves.

Preferred-stock liabilities - preferred-stock's main value is the right to a fixed dividend above the common shares, and is similar to a bond in that it is a fixed security. To value the preferred-stock liability, an analyst can follow this simple rule:
value preferred-stock at the highest of: par value (plus dividends), call price (plus dividends), or average market price. Sometimes, it might be more useful to create a par value, such as "the equivalent of a 5% dividend rate."

Most companies list preferred stock on the balance sheet at par value, but sometimes that is misleading.

Book value per share of common stock is arrived at by adding up all the assets (not including intangibles), subtracting all liabilities and stock issues ahead of the common, and then dividing by the number of shares. When calculating book value of preferred stock, do it in exactly the same way as you would common, but leave the junior issues out.

There are two other values that are important: current-asset value and cash-asset value.
Current assets consist of current assets alone minus all liabilities and claims ahead of the issue. (this excludes intangibles, miscellaneous, and the fixed assets).
Cash asset value consists of cash assets alone, minus all liabilities and claims ahead of the issue.
Free cash asset value assumes that the other assets of a company are enough to meet the liabilities ahead of the common, then the cash will be deducted to meet the balance of the senior claims ahead of it.

The asset-value is not as important as people think, because it has no real relation to earnings power; earning power and dividends are much more important when valuing a stock. But, it should not be ignored; the wise analyst will follow these rules:

1 - a safe bond or preferred stock almost always requires an ample margin of tangible assets over the senior claim, together with adequate earning power.
2 - paying many times the asset value for a common stock may be hazardous. also, purchasing a common stock at only a small fraction of asset value carries with it certain speculative possibilities.
3 - valuing or appraising common stock is dependable when the earning power is not more than the book value. A good combination of factors for purchase of stock include: earning power value, book value, and average market quotations in the past.
4 - a market quotation well under current asset value has significance - either the price is too low or the management needs to change its policies in some way.

The current ratio (assets versus liabilities) should be at least 2 to 1 and should also be compared with others in the same field.

Another measure of financial strength is the acid test. The acid test is: current assets exclusive of inventories should be at least equal to current liabilities.

Bank debt is not a problem in and of itself, but it is frequently a sign of weakness and requires careful observation.

A better way to calculate true earnings than adding up reported profits is to add the increase in surplus (and surplus reserves) and dividends paid. This is advantageous because earned surplus generally includes all gains and losses, while some may have been excluded in the income statement. All voluntary reserves must be included in earned surplus. Be careful not to include the changes in owner's equity that are not caused by earnings and cash dividends, ie. repurchase of shares by the company, extraordinary write-ups/downs of assets. These cases are usually cleared through the capital and capital surplus accounts and do not affect the earned surplus account.

In summary, when analyzing a balance sheet:
- all companies should state the value of their fixed assets for insurance purposes, or supply some other guide to their present value.
- companies on a LIFO basis should also give the replacement value of their inventory
- the statement of capital and surplus should clearly show the real claim of prefereed shares, for principal and back dividends, as against the total fund.

Thursday, March 5, 2009


Those following along might find the accounting above their heads. If this is the case, we suggest taking local college courses on accounting. In fact, it is suggested that all of our readers, save those who are experts, to continue to learn accounting. It is the language of money, and we must be fluent in order to become rich.

Wednesday, March 4, 2009

Income Statement

So far, we have learned that we must adjust the financial statements to make their results more representative of reality and to put companies in the same industry on a level playing field before we judge and select companies whose stock and bonds we will buy.

We have learned how to do this process to the income statement by doing the following steps:

1 - eliminate nonrecurrent items from single year analysis, but include them in long term analysis.

2 - exclude deductions or credits arising from the use of contingency and other arbitrary reserves

3 - place the depreciation (or amortization) allowance and the inventory valuation on a basis suitable for comparative study

4 - adjust the earnings for the operations of subsidiaries and affiliates to the extent they are not shown

5 - as a check, reconcile the allowance for Federal income tax with the reported earnings

Now, it is time to put this into practice. We cannot effectively perform these tasks without practice, so, to begin practicing, you can order company reports free of charge from

Now we will move on to the balance sheet...

Current Tax Rates

Here are the current income tax rates for companies:

Taxable income
$0 - 50,000: 15%
$50,000 - 75,000: 25%
$75,000 - 100,000: 34%
$100,000 - 335,000: 39%
$335,000 - 10,000,000: 34%
$10,000,000 - 15,000,000: 35%
$15,000,000 - 18,333,333: 38%
$18,333,333+: 35%

Personal Service CorporationsPersonal service corporations are subject to a flat tax of 35% regardless of their income.

Personal Holding CompanyPersonal holding companies are subject to an additional tax on any undistributed personal holding company income. (Code Sec. 541)

Year Rate
2007 15.0%
2006 15.0%
2005 15.0%
2004 15.0%
2003 15.0%
2002 38.6%
2001 39.1%
2000 and prior years 39.6%

Accumulated Earnings Tax - In addition to the regular tax, a corporation may be liable for an additional tax on accumulated taxable income in excess of $250,000 ($150,000 for personal service corporations). (Code Sec. 531)
Year Rate
2008 15.0%
2007 15.0%
2006 15.0%
2005 15.0%
2004 15.0%
2003 15.0%
2002 38.6%
2001 39.1%
2000 and prior years 39.6%

Monday, March 2, 2009

Security Analysis:Chapter 15

Now we will learn the final step of income statement adjustment: comparing the reported earnings to the income tax deduction.
This is necessary because many reports vary significantly - if the results are significantly different, the analyst can question the dependability of the published income.

There are many different reasons why the income accepted for tax purposes has charged to it less than the standard percentage rate of corporate tax:

- net income below a certain amount
- carry-forward or carry-back of losses
- income received on state or municipal bonds is tax free (rarely of importance)
- dividends from domestic corporation have a lower tax rate
- gains realized on the sale of capital assets
- mining and oil companies can use "percentage depletion", insstead of acounting depletion based on the book cost of the properties
- most investment companies or funds are allowed to save paying taxes if income is distributed to stockholders

The management of the company may do any of the following, which cause the reported income to differ from the taxable income:

- charging depreciation at a different rate in the income statement than the tax return
- by use of voluntary reserves
- by placing certain debits or credits into the surplus account, but including the tax result in the income account

The analyst should decide whether depreciation is correct or not compared to the tax deduction; if not, he should change it to fit accordingly.

On the subject of reserves and taxable income, Graham says,"When inventory is valued at LIFO for tax purposes ther are no resulting inventory reserves and no related difference between reported and taxable income. But when the LIFO result is obtained by setting up reserves, not recognized for tax purposes, a difference will, of course, be created."

One will find discrepancies from reserves in cases of:
- amortization of past-service pension payments
- operating reserves
- contingency reserves

Charges and credits through surplus accounts, where the income tax charges or credits are reflected in the income account, can distort earnings in various ways:
-losses or gains on property sales cleared through surplus
-bond discount charged off and redemption premium paid
-interest during construction

So, an analyst should determine why the reported profits and those indicated by the tax deduction differ. In the case of dividends or tax-free interest, no action is needed. If it is due to capital-gains, the anlyst should separate these from ordinary profits. In oil and mining companies he will expect a smaller tax allowance.

In the case of a carry-forward from a past-loss, the analyst should restate the earnings with a normal tax deduction for the profits.

If the reported earnings differ because of reserve entries, the analyst should exclude them and re-calculate the results.

If he finds a significant discrepancy which he is unable to explain, he should contact the company's treasurer.

Security Analysis:Chapter 14

In this chapter we learn how to deal with subsidiaries and affiliates. To clear up the definitions, we will define the words for our uses. A subsidiary is a company that is controlled by another company who owns more than 50% of its voting stock. An affiliate can either be like a subsidiary, a company owned by another but less than 50% of its voting stock, or one of two companies that are both controlled by a parent company.

Companies' treatment towards the reporting of the results of subsidiaries and affiliates varies:

standard treatment:
includes all subsidiaries

consolidated statements with exceptions:
similar to above but may lack things such as partially owned or foreign companies

largely unconsolidated statements:
lack most information about subsidiaries

affiliates as distinguished from subsidiaries
self explanatory

Next, we learn that some companies draw upon their unconsolidated subsidiaries in the form of special dividends to boost profits during a poor year. An analyst should include all important profits and losses pertaining to the company - adjustments are not necessary if they are, in total, less than 10%.

How do we deal with the question of "do losses in a subsidiary necessarily reflect the quality of the parent company being studied?" Perhaps, if the company could be run the same without the subsidiary, then they could be segregated and the loss of the subsidiary shown as a temporary loss, but if the company relies on its subsidiary as an important part of its operations, then it should obviously be included in the analysis, and the loss should be deducted from normal earnings.