Reading Financial Reports for Dummies (23 page)

If a company retrenches on its decision to pay dividends, the market price of the stock is sure to tumble. The company’s decision not to pay dividends after paying them in the previous quarter or previous year usually indicates that it’s having problems, and it raises a huge red flag on Wall Street.

Incurring new debt

When a company borrows money for the long term, this new debt is also shown in the financing-activities section. This type of new debt includes the issuance of bonds, notes, or other forms of long-term financing, such as a mortgage on a building.

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When you read the statement of cash flows and see that the company has taken on new debt, be sure to look for explanations in the management’s discussion and analysis and the notes to the financial statements about how the company is using this debt (see Chapter 9).

Paying off debt

Debt payoff is usually a good sign, often indicating that the company is doing well. However, it may also be an indication that the company is simply rolling over existing debt into another type of debt instrument.

If you see that the company paid off one debt and took on another debt that costs about the same amount of money, this likely indicates that the firm simply refinanced the original debt. Ideally, that refinancing involves lowering the company’s interest expenses. Look for a full explanation of the debt payoff in the notes to the financial statements.

If you compare the financing activities of Mattel and Hasbro, you see that Mattel paid off long-term debt, bought back stock, and paid dividends to deplete its cash holdings. Hasbro also paid dividends and purchased common stock. Mattel used $587.8 million of its cash for its financing activities, while Hasbro used $433.9 million.

When you look at the financing activities on a statement of cash flows for younger companies, you usually see financing activities that raise capital.

Their statements include funds borrowed or stock issued to raise cash.

Older, more established companies begin paying off their debt and buying back stock when they’ve generated enough cash from operations.

Recognizing the Special Line Items

Sometimes you see line items on the statement of cash flows that appear unique to a specific company. Businesses use these line items in special circumstances, such as the discontinuation of operations. Companies that have international operations use a line item that relates to exchanging cash among different countries, which is called
foreign exchange.

Discontinued operations

If a company
discontinues operations
(stops the activities of a part of its business), you usually see a special line item on the statement of cash flows that shows whether the discontinued operations have increased or decreased the 118
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amount of cash the company takes in or distributes. Sometimes, discontinued operations increase cash because the firm no longer has to pay the salaries and other costs related to that operation.

Other times, discontinued operations can be a one-time hit to profits because the company has to make significant severance payments to laid-off employees and has to continue paying manufacturing and other fixed costs related to those operations. For example, if a company leases space for the discontinued operations, it’s contractually obligated to continue paying for that space until the contract is up or the company finds someone to sublease the space.

Foreign currency exchange

Whenever a company has global operations, it’s certain to have some costs related to moving currency from one country to another. The U.S. dollar, as well as currencies from other countries, experiences changes in currency exchange rates — sometimes 100 times a day or more.

Each time the dollar exchange rate between two countries changes, moving currency between those countries can result in a loss or a gain. Any losses or gains related to foreign currency exchanges are shown on a special line item on the statement of cash flows called “Effect of currency exchange rate changes on cash.” Both Mattel and Hasbro show the effects of currency exchange on their statements in 2007 — Hasbro’s net cash increased by $3.6

million and Mattel’s increased by $8.1 million.

Adding It All Up

This is the big one, the highlight, the bottom line: “Cash and short-term investments at end of year.” This number actually shows you how much cash or cash equivalents a company has on hand for continuing operations the next year.

Cash equivalents
are any holdings that the company can easily change to cash, such as cash, cash in checking and savings accounts, certificates of deposit that are redeemable in less than 90 days, money-market funds, and stocks that are sold on the major exchanges that can be easily converted to cash.

The top line of the statement starts with net income. Adjustments are made to show the impact on cash from operations, investing activities, and financing. These adjustments convert that net income figure to actual cash available for continuing operations. Remember that this is the cash on hand that the company can use to continue its activities the next year.

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If you look at the statement of cash flows for Mattel and Hasbro, you can see that Mattel had about $901.2 million on hand at the end of December 2007 on net earnings of $600 million. Hasbro had about $774.5 million in cash and cash equivalents at the end of December 2007 on net earnings of $333 million. Even though Mattel had higher net income, its net cash actually decreased during the year, whereas Hasbro’s net cash actually increased.

In Part III, I delve more deeply into how the cash results of these two companies differ. I also show you how you can use the figures on the statement of cash flows and other statements in the financial reports to analyze the results and make judgments about a company’s financial position.

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Chapter 9

Scouring the Notes to the

Financial Statements

In This Chapter

▶ Describing the notes and their importance

▶ Understanding the fine print of accounting methods

▶ Finding out about financial commitments

▶ Getting acquainted with mergers and acquisitions

▶ Reading notes about pension and retirement

▶ Detailing segmented businesses and significant events

▶ Keeping an eye out for red flags

Would you ever sign an important contract without reading the fine print first? I didn’t think so. Remember this philosophy when you read financial statements because the corporate world certainly doesn’t escape the cliché about sweeping ashes under the rug. Hiding problems in the notes to the financial statements is a common practice for companies in trouble.

In this chapter, I explain the role of the notes as part of the financial statements, I discuss the most common issues addressed in the notes, and I point out some key warning signs that should raise a red flag if you see them mentioned in the notes. And to help you become a note-reading expert, I refer to the financial reports of Hasbro and Mattel (both toy companies) throughout the chapter. (You can view their complete annual reports at www.hasbro.

com and www.mattel.com.)

When searching for a company’s financial reports on its Web site, first find the corporation information section. Within that section you find the investor-relations section, which should contain links to the company’s annual and quarterly reports.

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Deciphering the Small Print

Figuring out how to read and understand the small print of the notes to the financial statements can be a daunting task. Most times, companies present these notes in the least visually appealing way and deliberately fill them with accounting jargon so they’re hard for the general public to understand. By making these notes so difficult to decipher, companies fulfill their obligations to the Securities and Exchange Commission (SEC) to give the required financial report to the reader, but at the same time, they make it hard for the reader to actually understand the information presented.

But don’t give up. These notes contain lots of important information that you need to know, including accounting methods used, red flags about a company’s finances, and any legal entanglements that may threaten the company’s future. I point out the key sections of the notes to the financial statements and what types of information to pluck out of these sections.

The first indication of the notes to the financial statements appears at the bottom of the financial statements. You see an indication that the accompanying notes are an integral part of the statement. In the same small print, you find the actual notes on numerous pages after the financial statements.

The information on the financial statement is just a listing of numbers. To really analyze how well a company is doing financially, you need to understand what the numbers mean and what decisions the company made to get the numbers. Sometimes a line item refers you to a specific note, but most times, you see only a general reference to the notes at the bottom of the statement.

The notes have no specific format, but you’re likely to find at least one note regarding several key issues in every company’s financial report. Read on to find out what these key issues are.

Accounting Policies Note: Laying

Out the Rules of the Road

The first note in almost every company’s financial report gives you the ammunition you need to understand the accounting policies used to develop the financial statements. This note explains the accounting rules the company used to develop its numbers. The note is usually called the “Summary of significant accounting policies.” Issues discussed in this note include:
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Asset types:
This describes the types of things owned by the company.

(See Chapters 4 and 6 for more information on assets.)

✓

Method of valuation:
This explains how the company values its assets.

(See Chapters 4 and 6 for more information on valuation.)

✓

Methods of depreciation and amortization:
This details the methods the firm uses to show the use of its assets. (See Chapters 4 and 6 for more information on depreciation and amortization.)

✓

How revenue and expenses are recognized:
This explains how the company records the money it takes in from sales and the money it pays out to cover its expenses. (See Chapters 4 and 7 for more information on revenue and expenses.)

✓

Pensions:
This lists the obligations the business has to its current and future retirees.

✓

Risk management:
This discusses what the company does to minimize its risk.

✓

Stock-based compensation:
This describes employee incentive plans involving stock ownership.

✓

Income taxes:
This explains the company’s income tax obligations and the amount the company paid in taxes.

Read the summary of significant accounting policies carefully. If you don’t understand a policy, research it further so you can make a judgment about how this policy may impact the company’s financial position. You can either research the issue yourself on the Internet or call the company’s investor relations office to ask questions. Also, compare policies among the companies you’re analyzing. You want to see whether the differences in the ways companies handle the valuation of assets or the recognition of revenues and expenses make it more difficult for you to analyze and compare the results.

For example, if companies use different methods to value their inventory, this can have a major impact on net income. I explain the impact of inventory valuation on net income in Chapter 15. Many times, you won’t actually have enough details to make apples-to-apples comparisons of two firms that use different accounting policies, but you need to be aware that the policies differ as you analyze the companies’ financial results and be alert to the fact that you may be comparing apples to oranges.

Depreciation

One significant difference in accounting policies that can affect the bottom line is the amount of time a company allows for the depreciation of assets.

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a 10- to 40-year span. The time frame used for depreciation directly impacts the value of the assets, which is recorded on the line item of the balance sheet called “Cost less accumulated depreciation.” A faster depreciation method reduces the value of these assets more quickly.

Depreciation expenses are also deducted from general revenue. A company that writes off its buildings quickly — say in 25 years rather than up to 40

years — has higher depreciation expenses and lower net income than a company that takes longer to write off its buildings. I discuss how depreciation works in greater detail in Chapter 4.

Revenue

You can find some noteworthy differences between companies by reading the revenue recognition section of the summary of significant accounting policies. Differences regarding the timing of revenue recognition can impact the total revenues reported. For example, one company may recognize revenue when a product is shipped to the customer. Another company may recognize revenue when the customer receives the product. If products are shipped at the end of the month, a company that includes shipped products will include the revenue in that month, but a company that only recognizes revenue when products are received may not include the revenue until the next month.

Other revenue recognition differences you should pay attention to include

✓

Sales price:
Some companies sell products with a fixed sales price, while others indicate that prices aren’t fixed and are determined between the company and the customer.