Reading Financial Reports for Dummies (35 page)

(Average current liabilities) = 0.67 (Current cash debt coverage ratio) For comparison’s sake, calculate the ratio for the previous reporting year as well:

$320,647,000 (Cash provided by operating activities, 2006) ÷ $896,782,000

(Average current liabilities) = 0.36 (Current cash debt coverage ratio) Hasbro ended 2007 in a stronger cash position than Mattel. Its current cash debt coverage improved from .36 in 2006 to .67 in 2007.

What do the numbers mean?

The current cash debt coverage ratio looks at a company’s ability to pay its short-term obligations. The higher the ratio, the better.

A negative “cash provided by operating activities” number is a possible danger sign that the company isn’t generating enough cash from operations.

You need to investigate why its cash from operations is insufficient. You should look for explanations in the notes to the financial statements or in the management’s discussion and analysis. If you don’t find the answers there, call the company’s investor relations department. Also look at analysis written by the financial press or independent analysts.

188
Part III: Analyzing the Numbers

It’s not unusual for growth companies to report negative cash from operations because they’re spending money to grow the company. However, a negative cash flow can’t be sustained for long, so be sure you understand the company’s long-term plans to improve its cash position.

Computing cash debt coverage ratio

You also want to look at a company’s ability to pay debt that’s due over the long term. Current liabilities only include debt that a company must pay in the next 12 months. Long-term liabilities are debts that a company must pay beyond that 12-month period. If you see signs that a firm may have difficulties meeting long-term debt, that, too, is a major cause for concern. Although you may find that a company generates enough cash to meet its current liabilities, if long-term debt levels are too high, the company will eventually run into trouble paying off its debt and meeting its interest obligations. You can measure a company’s cash position to meet long-term debt needs by using the
cash debt coverage ratio.

The formula for the cash debt coverage ratio is a two-step process:

1. Find the average total liabilities.

(Current year total liabilities + Previous year total liabilities) ÷ 2 =

Average total liabilities

2. Find the cash debt coverage ratio.

Cash provided by operating activities ÷ Average total liabilities = Cash debt coverage ratio

You can find the current- and previous-year total liabilities on the balance sheet. You can find cash provided by operating activities on the statement of cash flows.

Mattel

Using the cash provided by operating activities from Mattel’s 2007 cash flow statement and the average of its total liabilities from its 2007 and 2006 balance sheets, I show you how to calculate the cash debt coverage ratio. Using the two-step process, I first calculate the average total liabilities, and then I use that number to calculate the ratio:

1. Calculate average total liabilities.

$2,498,713,000 (2007 total liabilities) + $2,522,910,000 (2006 total liabilities) ÷ 2 = $2,510,811,500 (Average total liabilities)

Chapter 13: Making Sure the Company Has Cash to Carry On
189

2. Find the cash debt coverage ratio.

$560,532,000 (2007 cash provided by operating activities) ÷

$2,510,811,500 (Average total liabilities) = 0.22 (Cash debt coverage ratio) To judge whether a company’s cash provided by activities is improving, you calculate the ratio for both the current reporting year and the previous reporting year:

$875,946,000 (2006 cash provided by operating activities) ÷ $2,510,811,500

(Average total liabilities) = 0.35 (Cash debt coverage ratio) This ratio serves as evidence that Mattel’s cash position worsened from the end of 2006 to the end of 2007. Its cash position worsened because less cash came into the company from inventories and more went out in accounts payable. Mattel’s long-term debt decreased between 2006 and 2007 by about $86

million according to its balance sheet, but short-term borrowings increased by $349 million.

Hasbro

To show you how to calculate the cash debt coverage ratio, I use the cash provided by operating activities from Hasbro’s 2007 cash flow statement and the average of its total liabilities from its 2007 and 2006 balance sheets:

1. Calculate average total liabilities.

$1,851,971,000 (2007 total liabilities) + $1,559,015,000 (2006 total liabilities) ÷ 2 = $1,705,493,000 (Average total liabilities)

2. Calculate the cash debt coverage ratio for the current reporting year.

$601,794,000 (2007 cash provided by operating activities) ÷

$1,705,493,000 (Average total liabilities) = 0.35 (Cash debt coverage ratio) Calculate the ratio for the previous year as well:

$320,647,000 (2006 cash provided by operating activities) ÷ $1,705,493,000

(Average total liabilities) = 0.18 (Cash debt coverage ratio) Taking total liabilities into consideration, Hasbro ended 2007 in about the same cash position as Mattel. Hasbro carried a larger portion of its debt as long-term debt. You can see this by comparing the balance sheet line items for long-term debt for Mattel and Hasbro.

What do the numbers mean?

The cash debt coverage ratio looks at a company’s ability to pay its long-term debt obligations. As you can see, when long-term debt is taken into consideration, Hasbro’s position equalized with Mattel’s. Although Mattel 190
Part III: Analyzing the Numbers

carries a larger share of its debt as short-term debt, Hasbro’s debt structure is more heavily dependent on long-term debt. So calculating only one ratio or the other — current cash debt coverage ratio or cash debt coverage ratio —

won’t give you the full picture of a company’s financial health. You need to look at both ratios to be certain that the company is generating enough cash to cover both its short-term and long-term debt. In Chapter 9, I talk more about this debt-structure difference when looking at the explanations given in the notes to the financial statements.

As with the current cash debt coverage ratio, if you find a negative cash from operations number, be sure to look for an explanation in the notes to the financial statements or in the management’s discussion and analysis to find out why the cash flow from operations is negative. If you don’t find it there, call the company’s investor relations office to get the answers to your questions.

Calculating Cash Flow Coverage

Debt and the interest paid on that debt are not a company’s only cash requirements. Businesses also need cash for capital expansion to grow the company (including new plants, tools, and equipment) and pay dividends to investors.

As a shareholder, the only way you make money is when the company’s stock goes up in price. The stock market rewards a company with good growth potential by bidding up the price of its stock. Firms that show low growth prospects usually have few buyers and end up with lower stock prices. So you want to invest in companies that not only generate enough cash to pay their bills, interest, and the principals on their long-term debts, but also have money left over to pay dividends to their shareholders and grow their company. Remember that many growth companies don’t pay dividends at all but instead reinvest all profits toward future growth.

You can test whether a company is generating enough cash to cover its capital expenditures, pay its dividends, and pay its debt obligations by calculating the cash flow coverage ratio.

Finding out the cash flow coverage ratio

You use a two-step process to calculate the cash flow coverage ratio:

1. Calculate the company’s cash requirements.

Add the following:

Capital expenditures (listed in the investing activities section of the cash flow statement)

Chapter 13: Making Sure the Company Has Cash to Carry On
191

Cash dividends paid (listed in the financing activities section of the cash flow statement)

Interest expenses (listed on the income statement)

Current portion of long-term debt (listed in the financing activities section of the cash flow statement)

2. Calculate the cash flow coverage ratio.

Cash provided by operating activities ÷ Cash requirements = Cash flow coverage ratio

You can find cash provided by operating activities on the statement of cash flows.

Mattel

I use Mattel’s financial statements to show you how to calculate its cash flow coverage ratio:

1. Find Mattel’s cash requirements.

Capital

expenditures

$146,633,000

Plus cash dividends paid

$272,343,000

Plus interest paid

$70,974,000

Plus current portion of long-term debt

$100,000,000

Cash

requirements

$589,950,000

For capital expenditures, I used two line items on the cash flow statement: purchases of tools, dies, and molds; and purchases of other property, plant, and equipment. For current portion of long-term debt, I used the payments of long-term debt line item on the cash flow statement.

2. Calculate the cash flow coverage ratio.

$560,532,000 (2007 cash provided by operating activities) ÷ $589,950,000

(Cash requirements) = 0.95 (Cash flow coverage ratio)

Mattel didn’t generate enough cash from its operations to pay all its cash requirements for 2007. The .95 cash flow coverage ratio means that Mattel generated only enough cash to cover 95 percent of its cash requirements.

To cover the rest of its cash needs, a company has to either borrow money or draw down cash on hand from activities in previous years. Any firm that must draw down savings to maintain its operating activities is likely showing signs of trouble. Because Mattel has a large cash stash, it has enough to cover, but how long can it do that before the cash runs out and it gets in trouble? Anytime a company can’t meet its cash requirements, you should seriously reconsider investing in it.

192
Part III: Analyzing the Numbers

Hasbro

Now I use Hasbro’s financial statements to show you how to calculate its cash flow coverage ratio:

1. Find Hasbro’s cash requirements.

Capital

expenditures

$91,532,000

Plus cash dividends paid

$94,097,000

Plus interest paid

$34,618,000

Cash

requirements

$220,247,000

For capital expenditures, I used the additions to property, plant, and equipment line item on the cash flow statement. Hasbro had no long-term debt payments in 2007.

2. Calculate the cash flow coverage ratio.

$601,794,000 (2007 cash provided by operating activities) ÷ $220,247,000

(Cash requirements) = 2.7 (Cash flow coverage ratio)

Hasbro generated more than enough cash from its operations to pay all its cash requirements in 2007. This ratio shows that Hasbro generated enough cash to cover more than 200 percent of its cash requirements.

What do the numbers mean?

Mattel had to find sources other than operations to meet the shortfall in its cash requirements. Mattel used cash on hand at the beginning of the year to make up the cash shortfall, which you can see when you look at the cash and short-term investments on hand (at the bottom of the statement of cash flows) at the beginning of the year versus the end of the year.

Long term, Mattel seems a bit shaky on meeting its cash needs from operations, but neither company has a problem with
insolvency
(not being able to pay bills and debt obligations). At the bottom of Mattel’s cash flow statement, you can see that Mattel still held $901,148,000 in cash and short-term investments at the end of 2007, while Hasbro had $774,458,000 in cash and short-term investments at the end of 2007.

Companies that generate more than enough cash have a cash flow coverage ratio of more than 100 percent. The higher the ratio, the better. If you see a company that isn’t able to cover its cash requirements and has little left in cash and short-term investments, you should raise the red flag.

Part IV

Understanding How

Companies Optimize

Operations

In this part . . .

I show you how to analyze a company’s operations to

find out whether the management team is effectively

using its resources. After discussing the role that financial reporting plays in the basic budgeting process, I show you how to assess management’s effectiveness. I also give you the tools for measuring asset- and cash-management

efficiency.

Chapter 14

How Reports Help with

Basic Budgeting

In This Chapter

▶ Examining the budgeting process

▶ Figuring out how budgets are created

▶ Understanding the importance of monthly budget reports

▶ Putting internal budget reports to work