Evaluating Financial Statements– Few Important Metrics – Part 3– analyzing Beneish

We discussed three metrics, Altman-Z, Beneish M and Piotroski F, in my first blog on this subject. These metrics are very helpful in pointing out something unusual in financial statements of a company.  Companies will usually be able to explain flags raised by these metrics. One must carefully examine each factor contributing to red-flags. That is where an expert adds value.

For example, an analysis on Enron written by by graduate students of Cornel University is frequently quoted whenever Beneish M-Score is mentioned. However,  if you read that paper, students analyzed their results on Beneish M-score and concluded that “However, further examination of these indicators showed no cause for concern.” Now, in hindsight, we all know that there was a cause for concern.

Let me showcase another analysis that I did recently on Apple (AAPL). As you will notice in picture 1, Beneish analysis raises red flags for 2006, 2007, 2009 and 2010. You will need to analyze Apple’s annual reports to find causes of these red flags.

If you dig further into data for 2006 , you will notice a sudden change in AQI (asset quality index) and LVDI (Leverage Index). You will further find that apple paid $1.2 billion for prepayment of NAND memory modules, other current assets increased from 648M to 2270M and vendor non-trade receivables increase by $1B.

Data for 2007 tells us that receivables jumped from $1252M to $4029M. Also worth reading is a note in annual report

“The Company is exposed to credit risk on its accounts receivable and prepayments related to long-term supply agreements. This risk is heightened during periods when economic conditions worsen.

A substantial majority of the Company's outstanding trade receivables are not covered by collateral or credit insurance. The Company also has unsecured non-trade receivables resulting from the sale by the Company of components to vendors who manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has entered into long-term supply agreements to secure supply of NAND flash-memory and has prepaid a total of $1.25 billion under these agreements, of which $208 million had been used as of September 29, 2007. While the Company has procedures to monitor and limit exposure to credit risk on its trade and non-trade receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses.”

Beneish analysis also flags an unusual jump AQI to 4.46 in 2009. Annual report for 2009 indicates $16B increase in investment in long-term and short-term securities.

To summarize, examine results of these metrics for any red flags. Further analyze financial data contributing to these flags. That should lead you foot notes and explanations in financial statements. Remember that financial statements are prepared by firm and you should critically examine firm’s explanations for such changes. 

I will be delighted to hear your comments on my analysis and explanations. Any suggestions for improving this blog will be most welcome. If you will like to receive a copy of my calculator, please drop me an email.