Recently, I held a two-day financial intelligence session for a great group of ex-Goodrich managers. I’ve written “ex” because last July, UTC acquired Goodrich and everyone in the session became part of UTC.
During the two days, participants discussed UTC’s corporate and local goals, reviewed and analyzed the company’s financial statements and listened to the latest earnings call, focusing on elements related to the former Goodrich operation, how UTC put the transaction together and analysts’ questions. Participants heard how UTC financed the purchase by issuing corporate bonds which, due to UTC’s financial strength and the low cost of borrowing in the current market, carried an interest rate of 3%. Even better for shareholders, UTC had already paid off one-third of the Goodrich purchase and planned, through the earnings provided by Goodrich, increased operational efficiencies and divesting some divisions, to repay all the acquisition-related leverage within three years.
When participants compared UTC performance against its competitors over several years, however, UTC’s numbers didn’t seem to follow the results discussed in the earnings call. Participants found the balance sheet reflected the acquisition on measures like the debt to equity ratio. But when they looked at return on assets (ROA) and return on equity (ROE), UTC’s results were worse after it acquired Goodrich. Given the lack of analyst questions about the decrease in either of these measures, what was going on?
What drove the difference was how the statements were put together. Once we reviewed that, the picture came into focus. A balance sheet shows the company’s financial position on a given day and is only good for that day. In other words, once the acquisition was completed, all of Goodrich’s assets and liabilities became part of the UTC balance sheet. The income statement, however, is like a movie with a beginning, middle and end. Goodrich became an “actor” in UTC’s movie the day after the acquisition. That means, unlike the balance sheet where everything got included, only sales and costs after the acquisition date flowed into the income statement the class analyzed.
Since the acquisition closed July 26, 2012, the 2012 income statement included just 5/12 of Goodrich’s sales, costs and income. The balance sheet, however, included everything associated with Goodrich. Measures like ROA and ROE combine items from the balance sheet and income statement. Once participants understood that, they knew why analysts weren’t asking questions about the 2012 drop in ROA and ROE.
How statements are put together influences the numbers one sees. It’s critical to understand that and to ask questions as to the “whys” to build one’s financial intelligence.