Financials Statement Analysis gives an understanding of the key drivers in a business, its accounting & economic aspects, all of which can tell strikingly two different stories.
I. A business can look profitable based on the profit calculated according to generally accepted accounting principles (GAAP) but still loses money in real terms (by not matching up to its WACC).
II. A business can report its financial results in accordance with the generally accepted accounting principles, receiving an unqualified opinion from auditors, following the letter of the law but not its spirit by exploiting accounting loopholes.
As an example, a trader reporting its earnings based on US GAAP accounting principles is not required to discount its estimated future cash flows on commodity contracts.
In contrast the same company preparing their financial statements in accordance with the International Financial Reporting Standards (IFRS) is required to conduct an asset impairment test against the discounted stream of estimated future cash flows on commodity contracts. (but again, could follow the letter of the law but not its spirit).
With the prolonged commodity down-cycle, I theorize that the biggest obstacle for fairness in financial reporting is the principal-agent dilemma created by managers/sponsors who have raised outside-money on the equity market.
Can executives at a publicly listed commodity traders relying heavily on debt to finance their operations – buying and selling large volumes of oil and other commodities across the globe, voluntarily write down their book values and admit to bankers and investors what everybody else in the market seems to know: their assets are not worth what they were once purchased for.
[One can wonder why regulators would allow these commodity houses to float on the exchanges since their leverage, management fees, and positive spins about the commodity markets each quarter are more akin to what a hedge fund or the sell-side would do]
Cargill is the leader of financial reporting in the commodity industry.
Adjusted Operating Earnings
Cargill reports its financial results in accordance with U.S. generally accepted accounting principles (GAAP). They also report adjusted operating earnings, a non-GAAP measure that provides additional insight into the underlying financial performance [economic performance] of the company’s ongoing operations.
In calculating adjusted operating earnings, Cargill excludes the following six items.
The first three items relate to GAAP accounting treatments; the last three relate to “one-off” occurrences.
Committed to financial performance.
Over the last 5 years in the commodity industry was certainly not characterized by growth (contrarily to the conventional wisdom about commodities).
From Cargill’s five-year financial summary, we note a weak average ROE of 3.2%.
It is weak in a sense that at this speed, the shareholders will double their net worth in 22 years from now.
Some have seen in the figure above a solution to low margins with the business strategy of being more “aggressive”.
Amidst this weaker margins environment, Cargill has wisely opted to sanitize its balance sheet while others have seen the margins problem inversely, by leveraging.
The trader has been reducing its debt load from $22B to $10.2B so the company can preserve its financing costs comparative advantage in the future.
Cargill is a privately held company, the shareholders are the owners, and they’ve this authority over allocation decisions and ongoing operations. The business decisions at the upper-level management are strongly aligned with the shareholders; hence the principal-agent dilemma can be minimized.
Cargill are real business people thriving together.