For those that have read me for years at The Aleph Blog, this book will impart little that is new.  But, you get a set of powerful arguments in one integrated slim package.

I really liked this book.  The author took a broad view of bubbles, and developed five lenses through which to analyze them:

• Microeconomics
• Macroeconomics
• Psychology
• Politics
• Biological (contagion) analogies

This picks up the growth in debt, the misaligned short-term versus long-term incentives, crowd behavior, imitation, political agreement with booms, finger-pointing during busts, etc.

This book integrates the ideas of Keynes, Minsky, the Austrian economists, Soros (reflexivity), and others.  The author was very willing to interact with the view of those that might not fully agree with him, and yet bring out the areas where they do agree.

And the author tests the five lenses on five bubbles:

• The tulip bubble
• The Great Depression
• Japan in the late 80s
• The Asian crisis in 1997
• The US Housing Crisis 2006-?

Not surprisingly the crises chosen support the theory.  It would be interesting to see what the author would say on other bubbles, like the South Sea Bubble, the Tech Bubble, etc.

And so the author summarizes his case, and I think he does it well. But then he takes it a step further, and effectively says, “Well, is there an obvious bubble to point out now?”  And so he points out China.  The debts, the manipulation, malinvestment, bad incentives, etc.  You can read it for yourself and draw your own conclusions.

My main verdict on this book is that it provides a firm basis for evaluating bubbles.  I place it behind “Manias, Panics, and Crashes,” and “Devil Take the Hindmost,” but not by much.  To the author: Great job.

Quibbles

I disagree with the idea that booms and busts are a capitalist phenomenon.  Command-and-control economies do have booms and busts — the Great Leap Forward was a boom followed by a tremendous bust.  The effort to plant cotton in the Soviet Union was short-lived, leading to declining yields and destruction of the ecology of the Aral Sea.  There are more examples than this; at least in capitalism, the boom yields some decent rewards.

Who would benefit from this book:

Anyone who wants a better understanding of the boom-bust cycle will benefit from this book.  The author has nailed it in my opinion.  This book will help you to properly skeptical in the next unsustainable boom, and minimize your exposure to the bust.

If you want to, you can buy it here: Boombustology: Spotting Financial Bubbles Before They Burst.

Full disclosure: I asked the publisher for the book, and they sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I’ve been thinking a lot about bank reform lately.  Here’s the core of the problem: deposits are sticky in ordinary times, particularly once you have a guarantor of deposits like the FDIC.  But for some banks, they look to other short term funding, whether it is short CDs or repo funding.

Now to me a lot of the issue is asset-liability mismatch.  Banks borrow short and lend long.  That leads to banking panics.  Financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.

But there is a greater mismatch present, which I want to explore.  Every asset is financed with some liability or equity.  And, every liability is someone else’s asset, but not vice-versa, because assets owned free and clear are equity-financed.

Assets financed by debt are frequently mismatched short.  Long mismatches are rare because of the cost of financing being too high.  Now, if short mismatches are small, that’s not a problem.  There is enough flexibility in financial balance sheets to accept small mismatches.  Real disasters happen when long assets are financed in such a way that there is a risk that the financing will fail prior to the assets being paid off.

The fundamental mismatch in debts that finance assets is that the ultimate assets being financed are longer-dated than the financing.  We fund land, houses, buildings, plant & equipment, and do it off of deposits, savings accounts and CDs.  Some financial companies finance off of short-dated repo funding.  The reason that this mismatch is hard to avoid is that average individuals who save want short-dated assets that can be used for transactions.  That doesn’t fit well against the need to fund long-term assets.

The same problem exists in the municipal bond market.  Much more money wants to invest short, while municipalities want to borrow long.  This leads to a steep muni yield curve.  Commercial insurers writing long tail business, and wealthy people that can tolerate interest rate volatility end up buying the long end, and lower taxes in the process.

If banks were required to approximately match cash flows for assets not financed by equity, yield curves would steepen for other areas of the fixed income markets.  Areas of the financial market where there are long/strong balance sheets, such as Life Insurers, Commerical Insurers, Defined Benefit Pensions and Endowments would get higher yields for longer commitments.  Banks would become a lower ROE business, and that would be good, as there would be many fewer failures, and there would be fewer banks; we are over-banked.  Time to re-educate bankers for more productive activities.

Long dated floating-rate loans could be a solution for banks funding loans  off of short-dated lending, or, using interest rate swaps to achieve the same result.  The risk is that a bank locks in what proves to be a low spread on the asset, while funding costs are volatile.

A few final notes: 1) the standard of broadly matching asset and liability cash flows should be applied to all regulated financial institutions, including investment banks.  Only surplus assets not needed to match liabilities can be used for investments with equity-like risk. 2) There must be an unpacking of complex vehicles with embedded leverage to do the Asset-Liability management.  As examples:

• Securitizations
• Repo Funding
• Private Equity
• Hedge Funds
• Margin loans
• SIVs and the like

would need to be reflected as looking through to the items ultimately financed.  As an example, the AAA portion of a senior-sub securitization is long the loans, and short the certificates sold to the rest of the deal.

Repo funding has its own issues.  In a crisis, haircuts rise as asset values fall.  Institutions relying on that funding often fail at those times, and leaves losses to the repo lender.  There would need to be something reflected for the risk of repo market failure, though the grand majority of the losses go to the borrower, and not the lender.

3) Even short lending to those getting loans that do not fully amortize should be reflected as loans that are longer-dated, because of the risk of rates being higher, and refinancing is not possible.

I have more to say, but I’m going to hit the publish now.  Comments are welcome.

Have you ever seen a complex array of dominoes standing, waiting for the first domino to be knocked over, starting a chain reaction where amazing tricks will happen?  I remember seeing things like that several times on “The Tonight Show with Johnny Carson” back when I was a kid.

When the first domino is knocked over, the entire event doesn’t take long to complete — maybe a few minutes at most.  But what does it take to set up the dominoes?  It takes hours of time, maybe even a whole day or more.  Often those setting up the dominoes leave out a few here and there, so that an accident will spoil only a limited portion of what is being set up.

Those standing dominoes are an unstable equilibrium.  That is particularly true at the end, when the dominoes are added to remove the safety from having an accident.

Most books on the economic crisis focus on the dominoes falling — it is amazing and despairing to watch the disaster unfold, as the leverage in the system is finally revealed to be unsustainable.

This book is different, in that it focuses on how the dominoes were set up.  How did the leverage build up?  How was safety ignored by so many?

The beauty of this book is that it takes you behind the scenes, and describes how the conditions were created that led to a huge creation of bad debts.  I was a small and clumsy kid.  My friends would say to me during sports, “There are mistakes, but your error was so great that it required skill.”

The same was true of the present crisis.  There were a lot of skillful people pursuing their own private advantage, using new financial instruments which were harmless enough on their own, but deadly as a group.  So what were the great financial innovations that enabled the crisis?

• Creation of Fannie and Freddie, which led to an over-issuance of mortgages.
• Securitization, particularly of mortgages.  This led to a separation between originators and certificateholders. (And servicers, though the book does not go into servicers much.)
• Having parties that guarantee debt, whether GSEs, Guaranty Insurers, the Government, or credit default swaps [CDS]
• Loosening regulations on commercial banks, investment banks and S&Ls.
• Regulatory arbitrage for depository institutions.
• Loose monetary policy from the Federal Reserve, together with a disdain for regulating credit.  They saw Mexico and LTCM as successes, and thought that there was no crisis that could not be solved by additional liquidity.
• Bad rating agency models, and competition among rating agencies to get business.
• Regulators that required the use of rating agencies for capital modeling.
• The broad, misinformed assumption that real estate prices only go up.
• The creation of Value-at-risk, a risk management concept that has limited usefulness to true crisis management.
• The creation of CDOs that did not care for much more than yield.
• The development of synthetic CDOs, which allowed securitization to apply to corporate bonds, MBS, and ABS not owned by the trusts.
• The creation of subprime loan structures, where are that was cared for was yield.
• The creation of piggyback loans, so that people could put no money down for a home.

There are no heroes in this book, aside from tragic heroes who warned and were kicked aside in the hubris of the era.  Goldman Sachs comes out better than most, because they saw the crisis coming, and protected themselves more than mot investment banks.

I learned a lot reading this book, and I have read a dozen or so crisis books.  I didn’t learn much from the other books.  In this book, the authors interviewed hundreds of people who were integral to the crisis, and read a wide variety of sources that wrote about the crisis previously.

I found the book to be a riveting read, and I read it cover to cover.  I could not change into scan mode; it was that well-written.

This is the best book on the crisis in my opinion, because it takes you behind the scenes.  You will learn more from this book than any other on the crisis.

Quibbles

They don’t get the difficulties of being a rating agency.  There is the pressure to get things right over the cycle, and get it right on a timely basis.  These two goals are contrary to each other, and highlighting that conflict would have enhanced the book.

Who would benefit from this book:

Anyone willing to read a longish book could benefit from this book.  It is the best book on the crisis so far.

If you want to, you can buy it here: All the Devils Are Here: The Hidden History of the Financial Crisis.

Full disclosure: This book was sent to me, because I asked for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I was a reluctant convert to fair value accounting, because I like standardization in accounting that allows for comparisons across corporations.  Also, unlike the complaints that emanate from financial companies that argue that fair value is procyclical, my experience has been that financial companies mismark their assets high, no matter what.

But when I read this article in the New York Times, it hit me.  The reason that the banks complain about fair value accounting being procyclical, is that they are mismatching assets and liabilities.

Think about it.  The argument that the banks make is that they are solvent.  Unfavorable temporary asset price changes should not be reflected in the accounting.  But if liabilities are marked to market at the same time, the difference should be minimal if the cash flows of the assets and liabilities are matched, unless there is a credit problem with the assets.

The thing is, with most banks, they have a large amount of their financing through deposits, savings accounts, CDs, and repo funding, all of which is short-dated, relative to the length of their assets.  (For floaters, look at the maturity, not the reset period.)

Thus, it should be no surprise when a bank is mismatched short versus its assets that it would squawk during times of crisis, and complain about fair value accounting.  But the problem isn’t the fair value accounting; it is the cash flow mismatch.  Banks try to make extra money off of that mismatch in good times, only for it to become a deadly risk in times of bad credit and liquidity.

Let the banks do what the insurers do, and come close to matching assets and liabilities.  If they do that, the financial system will become a lot more stable, and financial crises will be much less common.

And at that point, it won’t matter what accounting system is used, so long as those using book value impair assets fairly.  Still, I would prefer fair value.  Investors deserve the best information, even if it complicates life for corporate managements.

Life insurance probably has the most complex accounting of any of the sub-industries. Part of this comes from the complexity of the contingencies underwritten, and most of the rest from producer compensation and the length of the contracts underwritten.

Life insurance and annuities are sold, not bought. In general, people have a mental bias toward thinking that they aren’t going to die in the immediate future. Annuities are often sold to people who won’t otherwise plan for their retirement. To overcome those biases, life insurance companies pay agents handsomely to originate policies. The commission is large enough that if the company expensed it, it would lose money on a GAAP basis every time it issued a policy. That’s why policy acquisition costs are deferred, set up as an asset, and amortized in proportion to the gross profitability of the business over the life of the business.

Reserving for term policies isn’t very complex, but reserves for cash value policies are set as the expected present value of future benefits less future premiums. Small changes in interest, mortality, and lapse rates can make large changes to reserve values. Other contingencies can affect different classes of policies as well; variable and indexed contracts rely on returns of the stock and bond markets. Higher assets under management mean higher fees.

There is a second business that most life insurance companies engage in. Since the companies would not be profitable if they invested in Treasury securities, they typically invest in corporate bonds, mortgage-backed securities, and other risky forms of debt. Some also invest in commercial mortgages and real estate. When there is stress in the credit and mortgage markets, life insurance companies do poorly.

In reviewing the performance of life companies as group from March 1994 through March 2004, one can see the effect of the major drivers of profitability. Underwriting was typically profitable for companies throughout the entire decade, so that was not a differentiating factor. Most of the shifts in profitability came from investment results. The credit cycle was generally positive to the beginning of 1999, negative 1999-2002, and positive after that. The equity market supported variable life and annuity writers until the bull market peak in March 2000, punished them until March 2003, and has rewarded them since then. The only period that deviated from this description was after the bubble popped in March 2000; life companies temporarily did better as equity investors fled technology stocks for the safety of stodgy sectors like life insurance.

The outlook for life insurance is no different than the past; it is tied to the outlook for the asset markets. If the credit and equity markets do well, so will life companies.

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Bringing it to the Present

Many of the things that I wrote back in 2004 regarding life insurers have proved prescient.  Life insurers have prospered as the asset markets have prospered, and suffered during the bear markets. On average, life insurers have done better than other financials, and better than the market as a whole since 2004.

One advantage the life insurers had 1999-2003 was that they got burned on CDOs and did not get caught in the bubble.  Even with other types of structured lending, life  insurers got more conservative 2003-2005, unlike most of the rest of the financial sector.  Life insurers noticed the poor underwriting, and stayed away.

It should be noted that there are life insurers that do a lot of variable business, and those that don’t.  Those that write a lot of variable life and annuities will be more sensitive to the stock market than those that don’t write a lot of variable business.

One final squishy spot: secondary guarantees.  With Universal Life and Variable Annuities, there are secondary guarantees where the reserving is questionable.  Also true of long-dated term policies… be aware that there might be some bombs lurking there, that will manifest in severe economic scenarios.

At present, I don’t own any pure life insurers.

I view the insurance industry as a loosely related group of sub-industries, where knowing something about one sub-industry tells little about any other sub-industry. Even within each sub-industry, companies can be very different from each other. This article will attempt to go through the vast wasteland that is the insurance industry, and attempt to point out some of the more interesting aspects of it.

There are three major risk factors with insurers: the underwriting cycle, investment returns, and expense control.

The Underwriting Cycle

The property/casualty insurance industry, like all mature industries, is a cyclical business. Cyclical businesses revolve around pricing, which involves the relative degree of capacity available in the industry.

The P/C industry derives its capacity to write business from the amount of surplus available to support business. This creates a four-phase cycle for the industry.

1.      When surplus is abundant, rate-cutting is prevalent, and generally poorer-quality business gets written in an effort to retain market share. Terms and conditions for insurance are loose. During this period, the prices of P/C companies fall relatively hard, as prospective estimates of profitability fall.

2.      After enough poor quality business gets written, and premium rates decrease meaningfully, high quality companies exit lines of business, or buy reinsurance, and low quality companies begin to look impaired. At these times, the stock prices of high quality firms fall a little, and low quality firms fall more.

3.      As the results of bad business become evident, reserves get raised, sometimes drastically, and surplus declines. When surplus is deficient, premium rates rise, and the stocks of companies that have survived the cycle rise dramatically. The best business from both a profit and risk control standpoint, gets written in this phase of the cycle Terms and conditions for insurance are tight.

4.      When surplus becomes adequate, premium growth rate slows, and stock prices rise slowly, at roughly the rate of retained earnings. This continues until surplus is abundant.

Catastrophes, when they happen, temporarily reduce surplus, and improve pricing. The companies least affected by the cat rally, and those most affected, tend to fall, or rise little. Major catastrophes can cause the cycle to bottom, or extend the positive side of the cycle, because surplus is diminished.

The rating agencies tend to cut ratings near phase 2, and raise them near phase 4. Diminished ratings decrease the amount of business that an insurer can write, and further limit the willingness of prospective purchasers of insurance, particularly long-tailed coverages, who want to be sure that the company that they buy insurance from will be around to pay claims.

Investment Returns

Strong investment returns increase surplus. In a bull market, some companies become more aggressive about writing business so that they can earn money from investments. This is particularly true of companies that sell coverages that result in long-tailed liabilities. Strong investment returns prolong phases 1 and 4 of the cycle. Investment returns were so strong throughout the 1990s that insurers often compromised underwriting standards, leading to much of the troubles that occurred in the industry from late 2000 to early 2003. Not only were investment returns low or negative, but the results of prior poor underwriting were realized through reserve adjustments that diminished surplus.

Expense Control

Every time a premium gets calculated, there is an estimate embedded in the premium for expense. Expenses typically take three forms: policy acquisition, claims adjustment, and operational. There is a tendency for expenses to drift higher when investment returns are strong, and when the market is softening due to greater competition.

Now I will discuss each sub-industry separately. Included in each discussion is a description of products, risks, and industry performance over the last ten years. The graphs show the performance of each sub-industry over the last ten years, derived from my own proprietary indexes. At the end, I give my outlook for each sub-industry.

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Bringing it to the Present

This series was written seven years ago in an all-nighter for my new boss.  The piece never saw the light of day, which annoyed me, though I liked my boss, and I never complained about it.

As I publish the ten-or-so pieces of it, because it was long, at the end of each installment, I will try to update the insurance subindustries to the present.  But it would be useful for anyone reading this to look at my presentation to the Southeastern Actuaries Conference on the Amazing Decade for Insurance Stocks.  Aside from that, I have lost the graphs of the original presentation.  My apologies.

Insurance is an amazing business.  Insurers make promises.  Many of the promises are uncertain with respect to amount and/or timing.  That makes the accounting complex.  This is one of the reasons why examining the qualitative aspects of an insurance company to understand how a management team makes decisions is so valuable.

Anyway, more to come here, and I hope you all enjoy this series.

Here are the eight rules with links to my recent pieces:

1. Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.
2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.
3. Stick with higher quality companies for a given industry.
4. Purchase companies appropriately sized to serve their market niches.
5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
6. Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
8. Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

For the most part these are rules that would only serve a value investor.  They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which  rules 7 and 8 spell out.  The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors.  Value traps are companies that are cheap, but cheap for a reason.  How do you avoid value traps?

• Try to have industry factors working for you (Rule 1)
• Look for companies that still have some room to grow (Rule 4)
• Avoid companies that are aggressive in their reporting of income (Rule 5)
• Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together.  They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

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This is the end of the “Portfolio Rules” series.  From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.

I general, I think our tax code is nuts, allowing deductions for interest, and not dividends.  That creates a pro-debt bias in the tax code, which we are suffering from now.  I would reverse it, and allow deductions for dividends, and not interest, which would create a pro-equity tax code.

Leaving that aside, though I think corporations should not be taxed, and individuals should be taxed more heavily, if you must tax corporations, do not create a separate tax accounting basis.  There should be no social engineering through the tax code.  Instead, tax corporations on their GAAP income.  If there is some other figure that they highlight to investors, such as operating earnings, tax them on that.

A taxation method like this gets rid of two sets of games:

1. The game of lowering taxable income below GAAP income.
2. The game of boosting reported income above GAAP income.

It is far better for the nation as a whole to have one set of strict rules on taxation that are almost impossible to avoid that the Swiss cheese tax code that we have gotten post-Reagan.  Discretion in the tax code allows the wealthy to avoid paying their fair share, regardless of what the tax rates are.  Why do you think wealthy Democrats support increases in tax rates and estate taxes?  Because they have clever ways of avoiding those taxes.

Again, I support true tax reform.  But who else would support such a fair system, when politicians support unfairness to aid them in getting re-elected?

News: I’m planning to submit my paperwork to Maryland on Monday for registering my investment advisory.  Aside from that, I am giving a talk on the Efficient Markets Hypothesis in New York City on Wednesday to the Society of Actuaries.  Onto tonight’s topic:

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Maybe I should rephrase that to be “avoid companies that abuse their accounting, overstating earnings,” because it is perfectly possible to overreport earnings, while staying within the boundaries of GAAP accounting.  Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

1. For nonfinancials, review the difference between cash flow from operations and earnings.  Companies where cash flow from operations does not grow and  earnings grows are red flags.  Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.  The latter portion of that rule can be applied to financials.
2. For nonfinancials, review net operating accruals.  Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.    The values of assets on the balance sheet are squishier than most believe.  The accruals there are not entirely trustworthy in general.
3. Review taxable income versus GAAP income.  Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.  b) management is clever in manipulating GAAP earnings.  It is the job of the analyst to figure out which it is.
4. Review my article “Cram and Jam.”  Does management show greater earnings than the increase in book value plus dividends?  Bad sign, usually.  Also, does management buy back stock aggressively — again, that’s a bad sign.

The idea is to see how honest and focused on the long term the management team is.  Management teams that cut corners in financial reporting will cut corners elsewhere, and deliver negative surprises to you.  That’s what I aim to avoid.

Financial statements encourage us to look at the bottom line.  The bottom line indicates the purpose of financial statement.  With an income statement, the purpose is to show us how much the company has profited.  With a balance sheet, the purpose is to show us how much the company is worth on a book value basis.  Now, book value is nowhere near perfect, but neither is it to be neglected, so neglect book value, particularly tangible book value at your peril.

Then there is the cash flow statement.  The main idea that there is to look at the change in net cash of the corporation.  But the subordinate goals of the cash flow statement are to show us how much cash has been generated from operations, how much has been used in investing, and how much has been acquired through financing.  There are many scams with the cash flow statement most of which try to recharacterize cash flows from financing or investing into operations if they are positive.

Finally, there’s the statement of shareholder equity.  This forgotten statement helps to clarify who owns what and clarify where book value comes from.  What is the effect on book value from new shares and their equivalents?  How was book value increased or decreased various corporate actions and why?

That said, the financial statements each have one major purpose, unless they can be adjusted for other purposes.  A stock investor will want to understand earnings per share and how it is changing.  But a bond investor will want to look at EBITDA, which shows how much cash is available to service debt.  To the stock investor, EBITDA is not very useful, except in the situation where the company might be a takeover target.  In that case, the acquirers may be looking at EBITDA because they will be financing the acquisition with a large slug of debt.

Someone doing an analysis of the industry on the whole is going to abstract from interest, taxes, depreciation, amortization, and will focus on gross revenues or maybe even revenues.  It all depends on the type of analysis that you are doing.  In one sense, every analyst must adjust the statements that they look at in order to reflect the claim priority of the investor for which they are analyzing.

Common stockholders should view statements differently than preferred stockholders who should view statements differently than junior debtholders who should view statements differently than senior debtholders. (Need I mention the bank debt holders or trade claimants? Nah, but they have different goals as well, and use the statements differently.)

Existing income statements and balance sheets and cash flow statements are designed for equity investors, because they run the calculations for the residual income claimant, the equity investor.  Bond investors, bank debt investors, have to think in these terms: what type of revenue or operating income is necessary for me to get paid dollar one, and for me to get paid in full?  And how likely are each of those events?  The same set of questions can be applied to the balance sheet where the debt investor asks what it would take for his claim to be impaired in bankruptcy, or wiped out in full.  And then the debt investor can ask how likely those events could be.

The boundary line answers for these questions may be easily calculated, but the probabilities will be more subjective, and depend on estimates of the likelihood of future revenue or operating earnings.

I don’t have a lot more to say here.  Just be aware of what question you’re trying to ask of financial statements, and if you’re other than the equity investor, make the necessary adjustments so that you get the answer that is tailored to your questions.