Reading Financial Reports for Dummies (34 page)

operations, investments, and financing activities.

In this chapter, I show you some basic calculations that help you determine the cash flow from sales and help you find out whether the cash flow is sufficient to meet the company’s cash needs. Throughout the chapter, I use Mattel and Hasbro (two leading toy companies) as examples to show you how to use these tools to evaluate a company’s financial health. You can find Hasbro’s financial statements, as well as its complete annual report, at www.

hasbro.com and Mattel’s at www.mattel.com.

Measuring Income Success

Looking at whether a company is generating enough cash income can help you determine the company’s
solvency
— its capability to meet its financial obligations (in other words, its ability to pay all its outstanding bills). If a firm can’t pay its bills, its creditors won’t be happy, and it could be forced to file bankruptcy or discontinue operations. In this section, I show you two ratios that can help you determine a company’s solvency based on its sales success.

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Part III: Analyzing the Numbers

Calculating free cash flow

The first step in determining a company’s solvency is to find out how much money the company earns from its operations that can actually be put into a savings account for future use — in other words, a company’s
discretionary
cash.
This is also called the
free cash flow.

A business with significant cash flow has a lot of flexibility to decide whether it wants to use its discretionary cash to purchase additional investments, pay down more debt, or add to its liquidity, which means to deposit additional funds in cash and
cash equivalent accounts
(including checking accounts, savings accounts, and other holdings that can easily be converted to cash). The formula for calculating the free cash flow is a simple one: Cash provided by operating activities – Capital expenditures – Cash dividends = Free cash flow

Cash flows from operating activities can be found at the bottom of the operating activities section of the statement of cash flows. Capital expenditures can be found in the investing activities section of the cash flow statement. Cash dividends paid can be found in the financing activities section of the statement of cash flows.

Mattel

Using Mattel’s 2007 and 2006 cash flow statements, I show you how to calculate the free cash flow:

2007

2006

Cash provided by operating

$560,532,000

$875,946,000

activities

Minus capital expenditures

Purchases of tools, dies,

(68,275,000)

(69,335,000)

and

molds

Purchases of other property,

(78,358,000)

(64,106,000)

plant, and equipment

Minus cash dividends

(272,343,000)

(249,542,000)

Free cash flow

$141,556,000

$492,963,000

As you can see, Mattel’s free cash flow dropped significantly from 2006 to 2007, by a total of about $351 million. The $23 million increase in dividends explains part of that drop, but more noteworthy is that Mattel’s cash provided by operating activities dropped by about $315 million. Taking a closer look at the cash flow from operating activities section, you can see a significant reduction in cash flow related to Mattel’s inventory line item (I show
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you how to investigate this number in Chapter 15). You also see a decrease in cash because $311.9 million was paid out in accounts payable, accrued liabilities, and income taxes payable. I show you how to analyze accounts payable in Chapter 16.

Clearly, Mattel is having trouble maintaining its previous cash levels. That could mean that the company decided to maintain lower cash levels and invest in new opportunities, or it could mean that it’s having difficulty generating new cash. But you can’t determine that with this calculation — it tells you that the company may have a problem, but it doesn’t give you a specific answer as to what the problem may be. What you do find out from this formula is that you must seek additional information by continuing the financial analysis of other line items (such as accounts receivable and inventory) and by reading the notes to the financial statements (see Chapter 9) or management’s discussion and analysis (see Chapter 5).

Hasbro

Now I show you how to calculate the free cash flow by using Hasbro’s 2007

and 2006 cash flow statements.

2007

2006

Cash provided by operating

$601,794,000

$320,647,000

activities

Minus capital expenditures

Purchases of property, plant,

(91,532,000)

(82,103,000)

and

equipment

Minus cash dividends

(94,097,000)

(75,282,000)

Free cash flow

$416,165,000

$163,262,000

Hasbro’s free cash flow is much stronger than Mattel’s for 2007. Also, Hasbro’s free cash flow increased from 2006 to 2007. This means that Hasbro has no trouble maintaining its cash-flow levels and actually improving its cash flow.

What do the numbers mean?

No question, the more free cash flow a company has, the better it’s doing financially. A company with significant free cash flow is in a strong position to weather a financial storm, be it a recession, a slowdown in sales, or another type of financial emergency.

If a company’s free-cash-flow number is negative, it must seek external financing to fund its growth. Negative or very low free-cash-flow numbers for young growth companies that need to make significant investments in new property, plant, or equipment are most likely not an indication of a big problem. But you 184
Part III: Analyzing the Numbers

should still look deeper into the financial reports, and especially the notes to the financial statements (see Chapter 9), to find out why the cash flow is so low and how the managers plan to raise additional capital. This is especially true if you see a negative free cash flow for an older company, which should immediately raise a red flag.

Figuring out cash return on sales ratio

You can test how well a company’s sales are generating cash using the
cash
return on sales ratio.
This ratio looks at profitability from cash rather than from the accrual-based income perspective. Remember, the accrual-based income perspective means that income and expenses are recognized when the transaction is complete, so there’s no guarantee that cash has been received. I talk more about this in Chapter 4.

Making sure a business is properly managing its cash flow is critical when assessing the company’s ability to stay in business and pay its bills. Sales are the primary way a company generates its cash.

Here’s the formula for calculating the cash return on sales ratio, which specifically measures cash generated by sales:

Net cash provided by operating activities ÷ Net sales = Cash return on sales

You can find the line item “Net cash provided by operating activities” on the cash flow statement in the operating activities section, and you find “Net sales” or “Net revenue” at the top of the income statement.

Mattel

I use Mattel’s cash flow and income statements to show you how to calculate the cash return on sales ratio:

$560,532,000 (Net cash provided by operating activities) ÷ $5,970,090,000

(Net sales) = 9.4% (Cash return on sales)

From looking at this equation, you can see that 9.4 percent of the dollars that Mattel generates from its sales provide cash for the company. Mattel’s
net profit margin
(the bottom line, or how much the company makes after all costs and expenses are subtracted), which I show you how to calculate in Chapter 11, is 10.05 percent. Mattel’s cash return on sales is slightly lower than its net profit margin. Although the difference isn’t significant, you do need to investigate the numbers more closely. As indicated above, Mattel’s inventory generated less cash in 2007 than in 2006. Also, significantly more was paid out in accounts payable, so that may be why the warning signs are here. You’ll know more after looking at the numbers in Chapters 15 and 16.

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Hasbro

Using Hasbro’s cash flow and income statements, I show you how to calculate the cash return on sales ratio:

$601,794,000 (Net cash provided by operating activities) ÷ $3,837,557,000

(Net sales) = 15.7% (Cash return on sales)

You can see that 15.7 percent of the dollars that Hasbro generates from its sales provide cash for the company. Hasbro’s net profit margin is 8.68 percent (see Chapter 11), which is a strong sign that Hasbro is efficiently converting its sales to cash.

What do the numbers mean?

The cash return on sales looks at the efficiency with which a company turns its sales into cash. Hasbro’s results show that it’s more efficient than Mattel at turning its sales dollars into cash. Add the fact that Mattel’s cash flow was negatively impacted by decreases in cash from inventory (see “Calculating free cash flow,” earlier in the chapter) and you get a clearer picture that Mattel may have a problem converting its sales to cash. In Chapter 16, I discuss how to evaluate a company’s accounts receivable turnover, which explains some of these cash problems.

Mattel’s cash return on sales is slightly lower than its profit margin, so the company may be showing the early signs of a problem or the strains of the toy recall in 2007, when problems in China may have cut significantly into profits.

Just bear in mind that a cash return on sales ratio that’s lower than the profit margin ratio can be a major red flag. The company may be using aggressive accrual accounting practices that enable it to report higher net profit. I discuss these types of practices in Chapter 23.

Checking Out Debt

In addition to noting how much cash a company generates from sales, you need to look at the cash flow going out of the company to pay its debts.

Whenever a business can’t pay its bills or the interest on its debt, it runs the risk of supply cutoffs and possible insolvency. Few vendors will continue sending products to a company that doesn’t pay its bills, and most creditors will seek ways to collect a debt if they don’t receive the interest and principal due on that debt.

You can check out a company’s ability to pay its debt by looking at its debt levels and the cash available to pay that debt. You do this by collecting numbers related to debt levels from the balance sheet and comparing them with cash-outflow numbers from the statement of cash flows.

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Part III: Analyzing the Numbers

Determining current cash

debt coverage ratio

You can determine whether a company has enough cash to meet its short-term needs by calculating the
current cash debt coverage ratio.
You calculate this number by dividing the cash provided by operating activities by the average current liabilities.

Here’s the two-step formula for calculating the current cash debt coverage ratio:

1. Find the average current liabilities.

Current liabilities for current year + Current liabilities for previous year

÷ 2 = Average current liabilities

2. Find the current cash debt coverage ratio.

Cash provided by operating activities ÷ Average current liabilities =

Current cash debt coverage ratio

You can find current liabilities for the current year and the previous year 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 current liabilities from its 2007 and 2006 balance sheets, I show you how to calculate the current cash debt coverage ratio.

Using the two-step process, I first calculate the average current liabilities, and then I use that number to calculate the ratio:

1. Calculate average current liabilities.

$1,570,429,000 (2007 current liabilities) + $1,582,520,000 (2006 current liabilities) ÷ 2 = $1,576,474,500 (Average current liabilities)

2. Calculate the ratio for the current reporting year.

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

$1,576,474,500 (Average current liabilities) = 0.36 (Current cash debt coverage ratio)

To determine whether a company’s cash provided by activities is improving, you should also calculate the ratio for the previous reporting year. In this case: $875,946,000 (Cash provided by operating activities, 2006) ÷

$1,576,474,500 (Average current liabilities) = 0.56 (Current cash debt coverage ratio)

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This comparison shows you that Mattel’s cash position worsened from the end of 2006 to the end of 2007. A ratio of 0.36 in 2007 shows that only slightly more than a third of its current liabilities were paid by cash taken in from sales, while in 2006, the ratio of 0.56 shows that close to 56 percent of its current liabilities were paid by cash taken in from sales. Taking a closer look at the cash flow statement, you can see the primary reason for the decline is related to decreases in cash from inventories. Also, more money was paid out in accounts payable. I show you how to take a closer look at these accounts in Chapters 15 and 16.

Hasbro

Now I use the cash provided by operating activities from Hasbro’s 2007

cash flow statement and the average of its current liabilities from its 2007

and 2006 balance sheets to show you how to calculate the current cash debt coverage ratio:

1. Calculate average current liabilities
.

$887,671,000 (2007 current liabilities) + $905,893,000 (2006 current liabilities) ÷ 2 = $896,782,000 (Average current liabilities)

2. Calculate the ratio for the current reporting year.

$601,794,000 (Cash provided by operating activities, 2007) ÷ $896,782,000