Evaluation of the Balance Sheet Quality of a Company

Recall from the previous section that high financial reporting quality of the balance sheet is stipulated by completeness, unbiased measurement, and clear presentation. The existence of off-balance-sheet liabilities (obligations) such as debts compromises the completeness of a balance sheet. Also, an analyst should consult with a company’s notes to the financial statement for a clear presentation. This is because companies have discretion regarding the items they present as single-line items and those that are grouped. Finally, unbiased measurement is essential for assets and liabilities whose valuation is subjective. These include impairment of property, plant, and equipment, and other assets, valuation of pension liabilities, valuation of the goodwill, and inventory valuation.

Here, we demonstrate the above by looking at the following example of a company with overstated goodwill.

Example: Goodwill

Consider XYZ Ltd., a hypothetical manufacturing and distribution company. A research analyst listed XYZ Ltd. among the companies with more goodwill on their balance sheet than their market values. XYZ’s income statement and balance sheet are as shown in the following excerpts, respectively:

$$ \textbf{Exhibit 1: XYZ Ltd. and Subsidiaries Consolidated Income Statement of Operations ($ millions, except per share amounts)}

$$\small{\begin{array}{l|r|r|r} \textbf{Year ended 31 December} & \textbf{2018} & \textbf{2017} & \textbf{2016}\\ \hline\text{Net sales} & 8,871.59 & 6,774.39 & 5,713.59\\ \hline\text{Cost of sales} & 6,327.29 & 5,174.09 & 4,460.79\\ \hline\textbf{Gross profit} & \textbf{2,544.30} & \textbf{1,600.30} & \textbf{1,252.80}\\ \hline\text{Administration and distribution expenses} & 3,008.69 & 2,237.89 & 1,922.49\\ \hline\text{Amortization expense of intangible}\\ \text{assets acquired} & 151.43 & 56.93 & 28.63\\ \hline\text{Impairment of goodwill and other}\\ \text{intangible assets} & 1,768.63 & – & -\\ \hline\text{Acquisition and integration costs} & 24.83 & 82.23 & 17.43\\ \hline\text{Restructuring and other charges} & 159.93 & 69.63 & 25.03\\ \hline\textbf{Operating (loss) profit} & \textbf{(2,569.21)} & \textbf{(846.38)} & \textbf{(740.78)}\\ \hline\text{Interest expense} & (367.27) & (199.17) & (144.17)\\ \hline\text{Loss on debt redemption} & (19.47) & {-} & (21.07)\\ \hline\text{Impairment of equity method investment} & (6.07) & – & -\\ \hline\text{Foreign currency exchange (losses) gains} & 17.03 & 17.13 & 22.93\\ \hline\text{Other expenses} & 8.03 & 2.93 & 20.43\\ \hline\textbf{(Loss) from continuing operations}\\ \textbf{before income tax provision} & \textbf{(2,936.96)} & \textbf{(1,025.49)} & \textbf{(862.66)}\\ \hline\text{Income tax (benefit) provision} & (244.47) & 76.93 & 104.93\\ \hline\textbf{Net (loss) earnings from continuing}\\ \textbf{operations} & \textbf{(2,692.49)} & \textbf{(1,102.42)} & \textbf{(967.59)}\\ \hline\text{Net earnings from discontinued operations} & 38.33 & 28.03 & -\\ \hline\text{Net gain on sale of discontinued operations} & 196.33 & – & -\\ \hline\textbf{Net (loss) earnings available to common}\\ \textbf{stockholders} & \textbf{(2,457.83)} & \textbf{(1,074.39)} & \textbf{(967.59)}\\  \end{array}}$$

$$ \textbf{Exhibit 2: Excerpt from XYZ Ltd. and Subsidiaries Consolidated Balance Sheets ($ millions, except share data)}

$$\small{\begin{array}{l|r|r}\hline\textbf{Year Ended 31 December} & \textbf{2018} & \textbf{2017}\\ \hline\textbf{Assets} & & \\ \hline\textbf{Current assets} &{} &{}\\ \hline\text{Cash and cash equivalents} & 908.09 & 932.07\\ \hline\text{Receivables} & 1,554.49 & 1,542.67\\ \hline\text{Inventories} & 964.89 & 1,005.97\\ \hline\text{Prepaid expenses and other current assets} & 708.89 & 783.37\\ \hline\textbf{Total current assets} & 4,136.36 & 4,264.08\\ \hline\text{Property and equipment, net} & 1,441.29 & 1,497.67\\ \hline\text{Goodwill} & 3,067.73 & 4,085.93\\ \hline\text{Intangible assets} & 1,368.19 & 2,264.17\\ \hline\text{Other assets} & 899.39 & 795.77\\ \hline\textbf{Total assets} & \bf{10,912.96} & \bf{12,907.62} \\ \hline\end{array}}$$

Questions

1. XYZ’s financial statements show that the number of common shares issued and outstanding in 2017 was 200,000,000. The price per share of XYZ’s common stock was around $15 per share in December 2017 and around $10 in June 2018; what was the company’s market value in June 2018?
2. How did the amount of goodwill as of 31 December 2017 compare with the company’s market value?
3. Why would the analyst’s evaluation of XYZ’s financial statements state that goodwill above the company’s market value is a warning sign to future write-off?

Solution to Question 1

$$ \text{XYZ Ltd. market cap in December 2017 = 200,000,000 shares × $15 per share = $3,000 million}

$$ \text{XYZ Ltd. market cap in June 2018 = 200,000,000 shares × $10 per share = $2,000 million}

Solution to Question 2

The amount of goodwill on XYZ’s balance sheet as of 31 December 2017 was $4,085.93 million. This amount exceeded the company’s market value of $3,000. Furthermore, goodwill and other intangible assets represented about 49% of XYZ’s total assets as of 31 December 2017.

Solution to Question 3

The amount of goodwill is overstated/overvalued, and so a future write-off is likely. This is because XYZ’s market capitalization is less than the reported amount of goodwill. In other words, the value implicitly attributed to all the company’s other assets is less than zero. However, if the market capitalization was precisely similar to the reported amount of goodwill, the value implicitly assigned to all the company’s other assets would equal zero. This would imply that the amount of goodwill is not overvalued and thus no likely future write-off.

Question

Base your answer on the information provided in Exhibit 2. The analyst’s statement, “XYZ Ltd. is among the companies with more goodwill on their balance sheet than their market values,” is most likely:

    A. Correct.

    B. Incorrect.

    C. Cannot be determined.

Solution

The correct answer is A.

Based on the information in Exhibit 2, the analyst’s statement appears to be correct. In the financial year ended 31 December 2018, XYZ Ltd. recorded impairment of goodwill and other intangible assets of $1,768.63 million. Remember that goodwill impairment is an accounting charge that companies record when goodwill’s amount recorded on the financial statements exceeds its market value.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (l) Evaluate the balance sheet quality of a company.