Reading Financial Reports for Dummies (25 page)

When you see operating leases that total close to 50 percent of a firm’s net fixed assets or that exceed the total of its long-term liabilities, be sure to use at least two-thirds of the obligations, if not all the payments, in your debt-measurement calculations. The fact that these obligations are only mentioned in the notes to the financial statements doesn’t negate their potential role in creating future cash problems for the company.

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Mergers and Acquisitions:

Noteworthy Information

Sometimes one company decides to buy another. Other times, two companies decide to merge into one.

If a company acquires another company or merges during the year covered by the annual report, a note to the financial statements is dedicated to the financial implications of that transaction. In this note, you see information about

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The market value of the company purchased

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The amount paid for the company

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Any exchange of stock involved in the transaction

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The transaction’s impact on the bottom line

When a company acquires another company, it frequently pays more for that acquisition than for the total value of the purchased company’s assets. The additional money spent to buy the firm falls into the line item called
goodwill.

Goodwill includes added value for customer base, locations, customer loyalty, and intangible factors that increase a business’s value. If a company has goodwill built over the years from previous mergers or acquisitions, you see that indicated on the balance sheet as an asset. I discuss goodwill in greater detail in Chapter 4.

In an acquisition, the acquired company’s net income is added to the parent company’s bottom line. This addition occurs even if the closing of the sale takes place at the end of the year. Many times, this addition can inflate the bottom line and make the net income look better than it actually will be when the companies are fully merged. Be sure to look closely at the impact any mergers, acquisitions, or even sales of parts of an acquired company have on net income.

A merger or acquisition may positively impact the bottom line for a year or two, and then the company’s performance drops dramatically as it sorts out various issues regarding overlapping operations and staff. Many times, the announcement of a merger or acquisition generates excitement, causing stock prices to skyrocket temporarily before dropping back to a more realistic value. Don’t get caught up in the short-term euphoria of a merger or acquisition when you’re considering the purchase of stocks. Read the details in the notes to the financial statements to find out more about the true impacts of the merger or acquisition transaction.

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Pondering Pension and

Retirement Benefits

You may not think of pension and other retirement benefits as types of debt, but they are. In fact, for most companies that offer pension benefits, the amount of money they owe their employees is higher than the amount they owe to bondholders and banks. Some companies offer both pensions (which are an obligation to pay retirees a certain amount for the rest of their lives after they leave the company) and other retirement benefits (which include contributions to retirement savings plans such as 401(k)s or profit-sharing plans).

When looking at the note about pension and other retirement benefits, find out which type of plan the company offers:

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Defined benefit plan:
The company promises a retirement benefit to each of its employees and is obligated to pay that benefit. This type of plan includes traditional retirement plans, in which employees get a set monthly or annual benefit from the company after retirement.

Defined benefit plans carry obligations for the firm for as long as an employee lives and, sometimes, for as long as both the employee and his spouse live. Determining how much that benefit will cost in the future is based on assumptions regarding how much return the company expects from its retirement portfolios and how long its employees and their spouses will live after retirement. As people live longer, pension obligations become much greater for those companies that offer defined benefit plans.

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Defined contribution plan:
The employer and employee both make contributions to a retirement plan. A 401(k) is an example of a defined contribution plan. The company isn’t required to pay any additional money to the employee after the employee retires and pulls her retirement funds from the company’s plan, rolling the funds into individual retirement savings or an annuity option. An
annuity
is a type of insurance policy that guarantees a set payment based on terms set up at the time the annuity is purchased.

In the notes to the financial statements, you find a calculation of the expected pension expense, the funding position of the plan, and the expectations for the future obligations of that plan based on complicated assumptions figured by an
actuary
(a statistician who looks at life span and other risk factors to make assumptions about the company’s long-term pension obligations). Insurance companies commonly use actuaries to determine costs for life, health, and other insurance products.

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In the pension and retirement benefits note, you find a chart that shows the annual payments currently being made to retirees. If you see these payments increasing more rapidly each year, it may be a sign of a long-term problem for the business. Companies should provide a table that shows the current plan assets at fair value and projects their ability to meet pension obligations in the future.

You need to compare a number of figures that companies use in calculating their estimates for pension obligations. You should see similar assumptions used by companies in similar industries. Numbers to watch include the

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Discount rate:
The interest rate used to determine the present value of the projected benefit obligations.

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Rate of return on assets:
The long-term return the company expects to earn on the assets in the retirement investment portfolio.

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Rate of compensation increases:
The estimate the company makes related to salary increases and the impact those increases have on future pension obligations.

Each of these rates requires that assumptions be made about unknown future events involving the state of the economy, interest rates, investment returns, and employee life spans. A company can do no more than make an educated guess. To be sure that the company’s guesses are reasonable, all you can do is check that it makes guesses that are similar to those of other companies in the same industry. You also should look for information in the notes about whether the company’s retirement savings portfolio is sufficient to meet its expected current and future pension obligations. This information is usually shown in a chart as part of the note. If the company’s retirement savings portfolio falls short, it could be a red flag that future cash-flow problems are possible.

Breaking Down Business Breakdowns

Can you imagine what it takes to manage a multibillion-dollar company? Just reading the numbers can be a daunting task. Think about how many products are sent out to make that many sales and how many people are needed to keep the business afloat.

Most major firms deal with their massive size by splitting up the company into manageable segments. This division makes managing all aspects of the business — from product development to product distribution to customer satisfaction — easier.

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These segments help the company track the performance of each of its product lines more easily. In the notes to the financial statements, you find at least one note related to these segment breakdowns. This note gives you details about how each of the company’s segments is doing, as well as about the product lines that fall under each segment.

You may also find some details about

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Target markets:
These are the key market segments that the company targets, such as age group (teens, tots, adults), locations (north, south, east, west), or interest groups (sportsmen, hobbyists, and so on). Target markets are limited only by the creativity of the marketing team, which develops the groups of customers that it wants to win over.

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The largest customers:
The company usually names the top customers that buy its products. For example, a manufacturer that sells a large portion of its products to major retailers such as Wal-Mart and Target will usually give some details about these relationships.

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Manufacturing and other operational details:
The company gives you information about how it groups its product manufacturing and where its products are manufactured. If the firm manufactures its products internationally, look for indications about problems that may have occurred during the year related to those operations. Sometimes labor or political strife can have a great impact on a company’s manufacturing operations. Also, weather conditions can greatly impact manufacturing conditions. For example, if the company’s manufacturing for a certain product line is in Singapore and Singapore experienced numerous damaging storms, the company may indicate that the problem occurred and that it had difficulty producing enough product for market.

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Trade sanctions:
All companies that operate internationally must deal with trade laws, which differ in every country. Some countries impose high tariffs on products coming from outside their borders to discourage importing. Sometimes countries impose sanctions on other countries for actions taken by politicians they disagree with. For example, the U.S. doesn’t allow trade with Cuba for political reasons, so a business that buys products from Cuba can’t import into the U.S. The U.S. and Europe are considering imposing sanctions on China because they don’t agree with some of China’s human rights policies and other policies. If the U.S. and Europe do so, importing products from China will be much more expensive for companies.

If a company faces specific marketing or manufacturing problems, you also find details about these problems in the note about segment breakdowns.

Don’t skip over this note!

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How a company breaks down its management segments varies depending on the industry and management preferences. Some companies divide into regions based on geography; others designate segments based on product lines or customer target groups.

If a company operates internationally, you usually see the U.S. market segments separated from the non-U.S. segments, and sometimes you find the international portion broken into regions, such as Europe, Asia, or the Middle East.

You won’t find any hard-and-fast rules about how to segment a business. How a company segments itself depends on how the company has operated historically or what the management style is of the company’s executives.

Reviewing Significant Events

Each year, every company faces significant challenges. One year, a firm may find out that its customers are suing it for a defective product. Another year, a business may get notice from a state or local government that one of its manufacturing facilities is polluting the environment.

You may also find in the notes mention of significant events that aren’t related to external forces, such as the decision to close a factory or combine two divisions into one.

You can look in a number of places in the notes for information on significant events. Sometimes an event has its own note, such as a note about the discontinuation of operations. Other times the event is just part of a note called

“Commitments and Contingencies.” Scan the notes to find significant events that impact the company’s financial position. You’re most likely to find significant events regarding topics such as

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Lawsuits:
The company should explain any pending lawsuits (usually in the “Commitments and Contingencies” note), which can sometimes have a huge impact on the company’s future. For example, Dow Corning, which is owned by Dow Chemical Corporation, is still suffering financially from lawsuits by women who face significant health problems from breast implants made by the company. The breast implants first hit the market in 1962. Suits were filed against the company beginning in the 1990s, when the breast implants ruptured and caused health problems.

Dow Corning ended up in bankruptcy trying to settle these lawsuits.

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Environmental concerns:
These concerns can become a significant event if the company is involved in a major environmental cleanup because of discharges from one of its plants. Cleanup can cost millions of dollars. For example, Exxon has paid more than $7 billion in repara-tions and fines for damages related to the
Valdez
oil spill in Alaska’s Prince William Sound in 1989.

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Restructuring:
Any time a company decides to regroup its products, close down a plant, or make some other major change to the way it does business, this action is called
restructuring.
You usually find an individual note explaining the restructuring and how it will impact the company’s income in the current year and future years.

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Discontinued operations:
Sometimes a company decides not to restructure but to close down an operation entirely. When this happens, you’re likely to find a separate note on the financial impact of the discontinued operations, which likely includes the costs of closing down facilities and laying off or relocating employees.

Many times the information included in these notes discusses not only the financial impact of an event in the current year but also any impact expected on financial performance in future years.