Saturday, July 19, 2008

It's All in the Notes: The Importance of Reading Notes to Financial Statements

Wilmington Capital Management (TSE: wcm.a) is a company that acquires and leases property to generate cash flow. This company made my value screen so I decided to analyze their historical financial statements in order to determine an approximate intrinsic value as of early 2007. I give credit to the management team at Wilmington for putting together easy to read annual financial statements. However, these annual financial statements act as a sobering reminder of why financial notes are an absolute must read for proper evaluation of public companies.

From the consolidated statement of earnings, there is a reference to the item "Income tax recovery" (note 8) for the amount of $11.23M. This is more than 10 times the net income before income taxes value! Investors in Wilmington counting on the net income per share value of $2.06 as likely in the future may be unpleasantly surprised.

We notice that the line item in question is recorded as operating earnings which is normal considering it is a tax related item. However, to value a company based on its free cash flows, we will want to use sustainable values that have a high probability of being repeatable into the future. If one works out free cash flows starting from the net income figure for Wilmington 2006, it will have included the massive income tax recovery value in the valuation. Is this income tax recovery item sustainable? Not likely but lets look at the financial notes to see what is going on here.

In note 8 to financial statements the corresponding disclosure is that this income tax recovery income item is actually in recognition of previously unrecognized tax assets. Great, how much more of those do they have? If there are substantially more tax assets available, we could account for these as reductions on future tax when we calculate future cash flows. Looking through all the fine print in note 8 we find that all tax assets are fully accounted for now on the books. There is a $0.2M future income tax asset on the balance sheet included under "Other assets" and that is it. No more delightfully huge "previously unrecognized tax items" ready to pop up and magically grow net income by a factor of 10.

Think of the Wilmington 2006 net income figure to remember that financial statements notes are a must read to understand the quality of existing earnings.

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