MARTIN S. FRIDSON is Chief Investment Officer at Lehmann Livian Fridson Advisors, a New York-based investment management firm founded on fundamental security analysis. He is past President of the Fixed Income Analysts Society.FERNANDO ALVAREZ has been a faculty member at Babson College, Rutgers University School of Business, NYU-Stern, and Columbia Business School. His research interests include the interaction of strategy, financial statement analysis, valuation models, and stock market reactions to business decisions.

• Preface to Fifth Edition xiAcknowledgments xvPart OneReading Between the Lines 1Chapter 1The Adversarial Nature of Financial Reporting 3The Purpose of Financial Reporting 4The Flaws in the Reasoning 8Small Profits and Big Baths 12Maximizing Growth Expectations 13Downplaying Contingencies 20The Importance of Being Skeptical 23Conclusion 27Part TwoThe Basic Financial Statements 31Chapter 2The Balance Sheet 33The Value Problem 34Comparability Problems in the Valuation of Financial Assets 36Instantaneous Wipeout of Value 38How Good Is Goodwill? 40Losing Value the Old-Fashioned Way 44True Equity Is Elusive 45Book Value May Overstate Reality 46Pros and Cons of a Market-Based Equity Figure 49The Common Form Balance Sheet 51Conclusion 53Chapter 3The Income Statement 55Making the Numbers Talk 55How Real Are the Numbers? 61Conclusion 85Chapter 4The Statement of Cash Flows 87The Cash Flow Statement and the Leveraged Buyout 89Analytical Applications 95In Defense of Slack 121Conclusion 123Part ThreeA Closer Look at Profits 125Chapter 5What Is Profit? 127Bona Fide Profits versus Accounting Profits 127Which Costs Count? 130Conclusion 134Chapter 6Revenue Recognition 135Making It Up at Gowex 135Globo’s Foreseen Fall from Grace 139Channel-Stuffing in the Drug Business 143A Second Take on Earnings 146Making the Numbers at M/A-Com 149Astray on Layaway 151Recognizing Membership Fees 152A Potpourri of Liberal Revenue Recognition Techniques 155Fattening Earnings with Empty Calories 156Tardy Disclosure at Halliburton 162Managing Earnings with Rainy Day Reserves 165Fudging the Numbers: A Systematic Problem 168Conclusion 171Chapter 7Expense Recognition 173Diamond Foods’s Movable Expenses 173Nortel’s Deferred Profit Plan 176Grasping for Earnings at General Motors 181Time-Shifting at Freddie Mac 184Conclusion 186Chapter 8The Applications and Limitations of EBITDA 187EBIT, EBITDA, and Total Enterprise Value 188The Role of EBITDA in Credit Analysis 193Abusing EBITDA 196A More Comprehensive Cash Flow Measure 198Working Capital Adds Punch to Cash Flow Analysis 201Conclusion 203Chapter 9The Reliability of Disclosure and Audits 205Where Was the Cash? 206Sloppiness Can Be a Red Flag 210How Manipulation Evades Detection 214Systematic Problems in Auditing 215Conclusion 220Chapter 10Mergers-and-Acquisitions Accounting 221Goodwill Goes Bad 223Double Trouble 224Conclusion 227Chapter 11Is Fraud Detectable? 229Telltale Signs of Manipulation 230Fraudsters Know Few Limits 233Enron: A Media Sensation 233HealthSouth’s Excruciating Ordeal 242Milk and Other Liquid Assets 249Trouble Was Brewing at Luckin 252Conclusion 254Part FourForecasts and Security Analysis 255Chapter 12Forecasting Financial Statements 257A Typical One-Year Projection 257Sensitivity Analysis with Projected Financial Statements 270Projecting Financial Flexibility 276Pro Forma Financial Statements 279Multiyear Projections 285Conclusion 299Chapter 13Credit Analysis 301Balance Sheet Ratios 302Income Statement Ratios 311Statement of Cash Flows Ratios 316Combination Ratios 318Relating Ratios to Credit Risk 326Conclusion 342Chapter 14Equity Analysis 343The Dividend Discount Model 344The Price-Earnings Ratio 350The Du Pont Formula 360Valuation through Restructuring Potential 364Advanced Equity Analysis 370Conclusion 373Notes 375Glossary 387Further Reading 405About the Authors 407Index 409

MARTIN S. FRIDSON is Chief Investment Officer at Lehmann Livian Fridson Advisors, a New York-based investment management firm founded on fundamental security analysis. He is past President of the Fixed Income Analysts Society.FERNANDO ALVAREZ has been a faculty member at Babson College, Rutgers University School of Business, NYU-Stern, and Columbia Business School. His research interests include the interaction of strategy, financial statement analysis, valuation models, and stock market reactions to business decisions.

• Preface to Fifth Edition xiAcknowledgments xvPart OneReading Between the Lines 1Chapter 1The Adversarial Nature of Financial Reporting 3The Purpose of Financial Reporting 4The Flaws in the Reasoning 8Small Profits and Big Baths 12Maximizing Growth Expectations 13Downplaying Contingencies 20The Importance of Being Skeptical 23Conclusion 27Part TwoThe Basic Financial Statements 31Chapter 2The Balance Sheet 33The Value Problem 34Comparability Problems in the Valuation of Financial Assets 36Instantaneous Wipeout of Value 38How Good Is Goodwill? 40Losing Value the Old-Fashioned Way 44True Equity Is Elusive 45Book Value May Overstate Reality 46Pros and Cons of a Market-Based Equity Figure 49The Common Form Balance Sheet 51Conclusion 53Chapter 3The Income Statement 55Making the Numbers Talk 55How Real Are the Numbers? 61Conclusion 85Chapter 4The Statement of Cash Flows 87The Cash Flow Statement and the Leveraged Buyout 89Analytical Applications 95In Defense of Slack 121Conclusion 123Part ThreeA Closer Look at Profits 125Chapter 5What Is Profit? 127Bona Fide Profits versus Accounting Profits 127Which Costs Count? 130Conclusion 134Chapter 6Revenue Recognition 135Making It Up at Gowex 135Globo’s Foreseen Fall from Grace 139Channel-Stuffing in the Drug Business 143A Second Take on Earnings 146Making the Numbers at M/A-Com 149Astray on Layaway 151Recognizing Membership Fees 152A Potpourri of Liberal Revenue Recognition Techniques 155Fattening Earnings with Empty Calories 156Tardy Disclosure at Halliburton 162Managing Earnings with Rainy Day Reserves 165Fudging the Numbers: A Systematic Problem 168Conclusion 171Chapter 7Expense Recognition 173Diamond Foods’s Movable Expenses 173Nortel’s Deferred Profit Plan 176Grasping for Earnings at General Motors 181Time-Shifting at Freddie Mac 184Conclusion 186Chapter 8The Applications and Limitations of EBITDA 187EBIT, EBITDA, and Total Enterprise Value 188The Role of EBITDA in Credit Analysis 193Abusing EBITDA 196A More Comprehensive Cash Flow Measure 198Working Capital Adds Punch to Cash Flow Analysis 201Conclusion 203Chapter 9The Reliability of Disclosure and Audits 205Where Was the Cash? 206Sloppiness Can Be a Red Flag 210How Manipulation Evades Detection 214Systematic Problems in Auditing 215Conclusion 220Chapter 10Mergers-and-Acquisitions Accounting 221Goodwill Goes Bad 223Double Trouble 224Conclusion 227Chapter 11Is Fraud Detectable? 229Telltale Signs of Manipulation 230Fraudsters Know Few Limits 233Enron: A Media Sensation 233HealthSouth’s Excruciating Ordeal 242Milk and Other Liquid Assets 249Trouble Was Brewing at Luckin 252Conclusion 254Part FourForecasts and Security Analysis 255Chapter 12Forecasting Financial Statements 257A Typical One-Year Projection 257Sensitivity Analysis with Projected Financial Statements 270Projecting Financial Flexibility 276Pro Forma Financial Statements 279Multiyear Projections 285Conclusion 299Chapter 13Credit Analysis 301Balance Sheet Ratios 302Income Statement Ratios 311Statement of Cash Flows Ratios 316Combination Ratios 318Relating Ratios to Credit Risk 326Conclusion 342Chapter 14Equity Analysis 343The Dividend Discount Model 344The Price-Earnings Ratio 350The Du Pont Formula 360Valuation through Restructuring Potential 364Advanced Equity Analysis 370Conclusion 373Notes 375Glossary 387Further Reading 405About the Authors 407Index 409

MARTIN S. FRIDSON is Chief Investment Officer at Lehmann Livian Fridson Advisors, a New York-based investment management firm founded on fundamental security analysis. He is past President of the Fixed Income Analysts Society.FERNANDO ALVAREZ has been a faculty member at Babson College, Rutgers University School of Business, NYU-Stern, and Columbia Business School. His research interests include the interaction of strategy, financial statement analysis, valuation models, and stock market reactions to business decisions.

• Preface to Fifth Edition xiAcknowledgments xvPart OneReading Between the Lines 1Chapter 1The Adversarial Nature of Financial Reporting 3The Purpose of Financial Reporting 4The Flaws in the Reasoning 8Small Profits and Big Baths 12Maximizing Growth Expectations 13Downplaying Contingencies 20The Importance of Being Skeptical 23Conclusion 27Part TwoThe Basic Financial Statements 31Chapter 2The Balance Sheet 33The Value Problem 34Comparability Problems in the Valuation of Financial Assets 36Instantaneous Wipeout of Value 38How Good Is Goodwill? 40Losing Value the Old-Fashioned Way 44True Equity Is Elusive 45Book Value May Overstate Reality 46Pros and Cons of a Market-Based Equity Figure 49The Common Form Balance Sheet 51Conclusion 53Chapter 3The Income Statement 55Making the Numbers Talk 55How Real Are the Numbers? 61Conclusion 85Chapter 4The Statement of Cash Flows 87The Cash Flow Statement and the Leveraged Buyout 89Analytical Applications 95In Defense of Slack 121Conclusion 123Part ThreeA Closer Look at Profits 125Chapter 5What Is Profit? 127Bona Fide Profits versus Accounting Profits 127Which Costs Count? 130Conclusion 134Chapter 6Revenue Recognition 135Making It Up at Gowex 135Globo’s Foreseen Fall from Grace 139Channel-Stuffing in the Drug Business 143A Second Take on Earnings 146Making the Numbers at M/A-Com 149Astray on Layaway 151Recognizing Membership Fees 152A Potpourri of Liberal Revenue Recognition Techniques 155Fattening Earnings with Empty Calories 156Tardy Disclosure at Halliburton 162Managing Earnings with Rainy Day Reserves 165Fudging the Numbers: A Systematic Problem 168Conclusion 171Chapter 7Expense Recognition 173Diamond Foods’s Movable Expenses 173Nortel’s Deferred Profit Plan 176Grasping for Earnings at General Motors 181Time-Shifting at Freddie Mac 184Conclusion 186Chapter 8The Applications and Limitations of EBITDA 187EBIT, EBITDA, and Total Enterprise Value 188The Role of EBITDA in Credit Analysis 193Abusing EBITDA 196A More Comprehensive Cash Flow Measure 198Working Capital Adds Punch to Cash Flow Analysis 201Conclusion 203Chapter 9The Reliability of Disclosure and Audits 205Where Was the Cash? 206Sloppiness Can Be a Red Flag 210How Manipulation Evades Detection 214Systematic Problems in Auditing 215Conclusion 220Chapter 10Mergers-and-Acquisitions Accounting 221Goodwill Goes Bad 223Double Trouble 224Conclusion 227Chapter 11Is Fraud Detectable? 229Telltale Signs of Manipulation 230Fraudsters Know Few Limits 233Enron: A Media Sensation 233HealthSouth’s Excruciating Ordeal 242Milk and Other Liquid Assets 249Trouble Was Brewing at Luckin 252Conclusion 254Part FourForecasts and Security Analysis 255Chapter 12Forecasting Financial Statements 257A Typical One-Year Projection 257Sensitivity Analysis with Projected Financial Statements 270Projecting Financial Flexibility 276Pro Forma Financial Statements 279Multiyear Projections 285Conclusion 299Chapter 13Credit Analysis 301Balance Sheet Ratios 302Income Statement Ratios 311Statement of Cash Flows Ratios 316Combination Ratios 318Relating Ratios to Credit Risk 326Conclusion 342Chapter 14Equity Analysis 343The Dividend Discount Model 344The Price-Earnings Ratio 350The Du Pont Formula 360Valuation through Restructuring Potential 364Advanced Equity Analysis 370Conclusion 373Notes 375Glossary 387Further Reading 405About the Authors 407Index 409