At a glance
- Despite admirable efforts there continues to be variance in how companies report their financial positions
- Differences in reporting do not necessarily constitute actual variance – the differences to an accountant are not the same as they are to an investor
- A full understanding of company financial statements should improve outcomes for investors
You won’t travel far if you can’t read the road signs (unless you have GPS, of course). Regardless, surely being able to read is better than not, and being able to read and understand financial statements is another form of literacy that can help with investing and earning the appropriate level of return for a given level of risk.
One might think that after all the years of debate and revisions, financial statements would be prepared in such a way that little interpretation or ability to “read” would be needed. Unfortunately, that is not the case. International standards have become more comparable, thanks to the efforts of the Financial Accounting Standards Board and the International Accounting Standards Board.
But even today, and within an agreed set of accounting standards, there are situations which require one to understand and account for differences – even among such similar firms as, for example, UPS and Fedex1, which both report according to US generally accepted accounting principles (US GAAP). Investors must understand these distinctions and how they affect the figures and ratios used for the purpose of comparing companies and assessing likely returns on investment. (To be clear, these are allowed, non-controversial items, but they cause material differences in reported results and can impact how a company appears over time, as well as how it compares to peers.)
Fedex and UPS are two of the largest parcel delivery companies in the US, and each are formidable competitors in many non-US markets. Fedex uses operating leases to obtain equipment and property to a much larger extent than UPS. Much of this leasing is for essential facilities, for example at airports. Fedex may not even have a choice about this – perhaps it is impossible to actually buy and finance these assets. Regardless, this is not a comment on how a company should or should not finance assets. It is simply to point out that where there is a difference in approach, one needs to understand the implications – not only on the balance sheet and income statement, but also the cashflow statement.
A company that uses lease financing will most likely report lower EBITDA (earnings before interest, taxes, depreciation, and amortisation), lower cash from operations and lower capital expenditure. In addition, key ratios such as net debt to EBITDA and return on average assets will be different than if the same company were to use debt. For clarity, EBITDA is not a term used in generally accepted accounting principles, but it is commonly used by management teams and analysts. The differences are essentially that if a company owns assets and finances them, they will have a corresponding interest expense as well as the depreciation expense in future periods. If they use leases, those items are replaced by rental expense. All rental expense would be deducted when calculating EBITDA, and the same would be true for operating cashflow.
Figure 1 is an outline of how Fedex reported its results at its last year-end (May 2023) and how they would have been reported had they not used lease financing.
Figure 1: Fedex accounts, lease and on-lease
Source: Columbia Threadneedle Investments’ analysis of company reports, May 2024
Credit investors tend to care about net debt divided by EBITDA (nd/ebitda) – the lower the figure, the better. As per Figure 1, a number like 2.8x would ordinarily be considered much healthier than 3.5x. Margins are also looked at, and EBITDA multiples are commonly used in M&A discourse. “Cash is king” applies in credit as in other contexts and we can see from this example that operating cashflow is significantly affected by the choice of financing.
A change in Fedex’s policy – for example, to replace a portion of the operating leases with debt – could give a misleading impression that the company was reducing leverage, as the nd/ebitda figure would improve. The EBITDA margin would also improve, implying – again incorrectly – that the company was becoming more efficient. And lastly, cash from operations would grow.
Another pitfall awaiting an unsuspecting financial statement user would be to compare the reported figures from Fedex and UPS and draw inappropriate conclusions. Figure 2 is based on the above Fedex figures and the corresponding data for UPS, unadjusted. UPS does use some leases, just to a much smaller degree. As can be seen, Fedex “as reported” has considerably higher leverage and lower margins than UPS. But adjusted, Fedex is considerably more similar to UPS.
Figure 2: Fedex accounts, lease and on-lease … and UPS
Source: Columbia Threadneedle Investments’ analysis of company reports, May 2024
How one considers the topic of asset financing may make the difference between viewing UPS and Fedex as companies with very similar businesses achieving fairly similar results, or seeing one as an efficient, disciplined capital allocator (UPS) and the other as a bit of a sloppy, highly indebted runner-up. A more in-depth understanding will help the bond investor avoid overpaying for one while possibly ignoring the other entirely.
