Brian,
Take a look at this article on Boston Chicken and you will see one of the many ways accounting tricks can be used to make a companies situation seem better than it is:
An Investment Opinion by Dale Wettlaufer
FOOL PLATE SPECIAL: Boston Chicken Carves Up Balance Sheet
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Boston Chicken (Nasdaq: BOST) finally came out and said it today -- the liabilities are rock solid but the assets look a little shaky. The
parent company of Boston Market and Einstein/Noah Bagel Corp. (Nasdaq:
ENBX) announced that it will take a $250-$350 million charge to
establish a provision for loan losses and to write down certain assets.
In the past, the company has said that its reviews of developer progress and collateral backing loans made to area developers and other Boston Chicken store operators have shown no need to establish loan loss reserves. A prudent investor would have looked at Boston Market's accounting policies and mentally marked down the value of those assets to some degree. Now the balance sheet is coming into line with what's really going on at the company.
Taking only half of the above-mentioned charges as a loan loss reserve
would wipe out the value of about 11% of the company's loans to
Einstein/Noah Bagel and Boston Chicken developers. In all, this charge
could erase a third of the company's book value, which is one possible
conclusion that one might have come to a year ago when looking at Boston Chicken's uneconomic return on owners' equity (ROE). At that time, things were supposedly going very well for the company, with store-level cash flow margins coming in at 19% in the fourth quarter alone. Why, then, was the company's return on owners' equity 6.6% for 1996? Since ROE is a product of earnings and shareholders' equity, one could question the reliability of either one of those factors in assessing the real earnings power of Boston Chicken.
With no loan loss provisions flowing through the income statement to
conservatively state the company's financial position, one might say the earnings component of ROE was overstated. Putting together individual experience with flagging store attendance and looking at the company's major assets, one might just go to the balance sheet and take a cut at the valuation of loans to area developers. Giving those loans a haircut of 10%, we only get to ROE of 7.1%. To get to an ROE of 11%, which would satisfy those equity holders looking for at least a market rate of return on capital they have invested, an investor would have to mark down average loans to developers and operators by 50%. Reducing loans by that amount for 1996 would have brought down owners' equity by a little less than 38%, which is not coincidentally in the ballpark of today's whack to owners' equity. When there is doubt of the returns a company is generating, it can be helpful to reverse-engineer the financial statements of a company in this way. If earnings seem unbelievably large, an investor might assume a normalized ROE and look at the multiples from there. When ROE looks uneconomic, an investor might want to restate the balance sheet to set ROE equal to a normal return and then see what happens. |
