Reading Financial Reports for Dummies (32 page)

Comparing ROE to ROA for Mattel and Hasbro, you can see that both companies’ ROEs look better than their ROAs:

ROA

ROE

Mattel

12.5%

26%

Hasbro

10.3%

24%

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The primary reason that ROE often looks better than ROA is that debt isn’t included in ROE. When you see comparisons of company statistics, you frequently find an ROE but no mention of an ROA because many companies believe ROA is primarily a statistic to be used by management and the company’s debtors. Take the extra time to determine the company’s ROA, and compare it with that of other firms in the industry. You’ll have a much better idea of how well the company generates its profit when you take both debt and equity into consideration.

The Big Three: Margins

You need to investigate three types of margins when you evaluate a company based on its financial reports.
Margins
show you how much financial safety the company has after its costs and expenses. Each of the three margins I discuss — gross margin, operating margin, and net profit margin — shows what the company has left to work with at various stages of the profit calculation.

Dissecting gross margin

Gross margin
looks at the profit margin based solely on sales and the cost of producing those sales. It gives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted. These costs can include discounts offered, returns, allowances, production costs, and purchases. I talk about these costs in greater detail in Chapter 7.

To calculate gross margin, divide gross profit by net sales or revenues: Gross profit ÷ Net sales or revenues = Gross margin

You can find gross profit at the bottom of the sales or revenue section of the income statement. Net sales are at the top of the same section.

Using numbers from Mattel’s income statement, you can calculate its gross margin:

$2,777,300,000 (Gross profit) ÷ $5,970,090 (Net sales) = 46.52% (Gross margin)

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Part III: Analyzing the Numbers

Mattel made a gross profit of 46.5 percent on each dollar of sales. Compare this number with Hasbro’s gross margin (using numbers from its income statement):

$2,260,936,000 (Gross profit) ÷ $3,837,557,000 (Net sales) = 58.92% (Gross margin)

Hasbro has about 12 percent more revenue left after it subtracts its direct costs than Mattel has, which shows that Hasbro has better cost controls on the purchase or production of the toys it’s selling.

Investigating operating margin

The
operating margin
takes the financial report reader one step further in the process of finding what’s left over for future use and looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product. These costs include advertising, selling (sales staff, sales offices, sales materials, and other items directly related to the selling process), distribution, administration, research and development, royalties, and other expenses.

Selling and advertising expenses aren’t factored into the cost of goods sold, which were subtracted out before calculating gross margin, because these expenses usually involve the sale of a number of products or even product lines. These expenses can rarely be matched to a specific sale of a specific product in the same way that the cost of actually manufacturing or purchasing that product can be matched.

Divide operating profit by net sales or revenues to calculate the operating margin:

Operating profit ÷ Net sales or revenues = Operating margin You can find net sales or revenues at the top of the income statement and the operating profit at the bottom of the expenses-from-operations section on the income statement.

Using numbers from Mattel’s income statement, you can calculate the operating margin:

$730,078,000 (Operating profit) ÷ $5,970,090,000 (Net sales) = 12.23%

(Operating margin)

Mattel made an operating margin of 12.23 percent on each dollar of sales.

Compare this number with Hasbro’s operating margin (using numbers from its income statement):

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$519,350,000 (Operating profit) ÷ $3,837,557,000 (Net sales) = 13.53%

(Operating margin)

Hasbro made an operating profit of 13.53 percent on each dollar of sales.

You can see the tables have turned. Now that all indirect expenses are factored into the equation, you can see that Hasbro doesn’t have as big an advantage over Mattel on costs. Hasbro’s operating profit is just 1.3 percent higher than Mattel’s.

One key expense factor that hurts Hasbro is that its royalty expenses (more than $316.8 million) are much higher than Mattel’s. Hasbro buys the rights to toys instead of developing them in-house, so it must pay royalties on its toys.

Mattel traditionally develops more of its toys in-house and has much lower royalty payments. In fact, when you look at Mattel’s income statement, you don’t even see royalties separated out from other selling and administrative expenses.

Companies with an operating margin that’s higher than the industry average are usually better at holding down their cost of goods sold and operating expenses. Maintaining a higher operating margin means the company has more price flexibility during hard times. If a company with a higher operating margin must lower prices to stay competitive, more room is available to continue earning profits even when products must be sold for less.

Catching the leftover money:

Net profit margin

The
net profit margin
looks at a company’s bottom line. This calculation shows you how much money the company has left after it has deducted all expenses — whether from operations related to the production and selling of the company’s products or from nonoperating expenses or revenue not related to the company’s sales of products or services.

For example, a nonoperating revenue would be interest earned on a company’s bond holdings. That money isn’t generated by operations but is still considered earnings for the company. After the operating-income line on the income statement, you most likely see a line for interest expense. This line represents the interest the company paid out on corporate debt. You also see income taxes expense, which indicates the amount the company paid in taxes. These are two of the biggest charges left to subtract from operating income. The only exception to this rule is if a large extraordinary charge from a special event, such as discontinued operations or the purchase or sale of a division, appears on the income statement. Any extraordinary charges will also appear on the income statement after the operating income line.

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Part III: Analyzing the Numbers

To find net profit margin, divide net profit by net sales or revenues: Net profit ÷ Net sales or revenues = Net profit margin

You find the net profit at the bottom line of the income statement; it may also be called “net income” or “net loss.” Net sales or revenue is on the top line of the income statement.

You can calculate the net profit margin using numbers from Mattel’s income statement:

$599,993,000 (Net profit) ÷ $5,970,090,000 (Net sales) = 10.05% (Net profit margin)

Mattel made a net profit of 10.05 percent on each dollar of sales. Now calculate Hasbro’s net profit margin using numbers from its income statement: $333,003,000 (Net profit) ÷ $3,837,557,000 (Net sales) = 8.68% (Net profit margin)

Hasbro made a net profit of 8.68 percent on each dollar of sales. Comparing Mattel’s and Hasbro’s net profit margins, Mattel appears to be more successful than Hasbro at generating a net profit per dollar of sales. The key question investors must then ask is whether Mattel will perform as well in the future.

Looking to the future

When you decide to invest in a company, you

little profit. If the company grows at a rate of

want to consider one that has a good history of

10 to 15 percent per year or more, you’ll likely

managing its assets well and making a profit.

see an ever-increasing value of your stock pur-

Even more important, you need to know what

chase. If you’re looking at a mature company

the company’s growth prospects are.

that has a solid market base but isn’t expected

to grow, you should be more concerned about

As a new investor, you’re most interested in

what that company pays out to its investors in

future growth because that’s how you make dividends than about its growth prospects.

your money. If the company stagnates and the

stock price doesn’t go up, your investment sees

Chapter 12

Looking at Liquidity

In This Chapter

▶ Calculating various debt and income ratios

▶ Looking at debt in relation to equity and capital

Making money is great, but if a business ties up too much of its money in nonliquid assets (such as factories it can’t easily sell) or carries too much debt, it won’t be around long to make more money. A company absolutely must have the cash it needs to carry out day-to-day operations and pay its debt obligations if its owners want to stay in business.

Lenders who have money wrapped up in a company follow debt levels closely. They definitely want to be sure they’re going to get their money back, plus interest. As an investor, you need to take a close look at a company’s debt, too, because your investment can get wiped out if the company goes bankrupt. So if you’re investing in a company, you want to be certain that the company is liquid and isn’t on the road to debt troubles.

So how do you make sure that the firm you invest in isn’t about to spiral down the toilet, taking all your money with it? Well, you need to check out the company’s ability to pay its bills and pay back its creditors. But looking at one company doesn’t give you much information. Instead, compare the company with similar companies, as well as with the industry average. Doing so gives you a better idea of where the company stands.

In this chapter, I show you how to calculate a company’s ability to pay the bills by looking at debt ratios, comparing its debt to its equity, and comparing its debt to its total capital. (If you’re starting to sweat and/or your brain is shutting down because of the impending mathlete workout, don’t worry —

things aren’t as difficult as they sound!)

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Part III: Analyzing the Numbers

Finding the Current Ratio

One of the most commonly used debt measurement tools is the
current ratio,
which measures the assets a company plans to use over the next 12 months with the debts it must pay during that same period. This ratio lets you know whether the company will be able to pay any bills due over the next 12

months with assets it has on hand. You find the current ratio by using two key numbers:

✓

Current assets:
These are cash or other assets (such as accounts receivable, inventory, and marketable securities) the company will likely convert to cash during the next 12-month period.

✓

Current liabilities:
These are debts that the company must pay in the next 12-month period, including accounts payable, short-term notes, accrued taxes, and other payments.

I talk more about current assets and current liabilities in Chapter 6.

Calculating the current ratio

The formula for calculating the current ratio is:

Current assets ÷ Current liabilities = Current ratio

Using information from the balance sheets for Mattel and Hasbro, here are their current ratios for the year ending December 2007:

Mattel

$2,592,936,000 (Current assets) ÷ $1,570,429,000 (Current liabilities) = 1.65

(Current ratio)

So Mattel has $1.65 of current assets for every $1 of current liabilities.

Hasbro

$1,888,240,000 (Current assets) ÷ $887,671,000 (Current liabilities) = 2.13

(Current ratio)

So Hasbro has $2.13 of current assets for every $1 of current liabilities.

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What do the numbers mean?

The key question to ask is whether a company’s current ratio shows that it’s able to cover short-term obligations. Generally, the rule of thumb is that any current ratio between 1.2 and 2.0 is sufficient for a business to operate. Keep in mind that the ratio varies among industries.

A current ratio below 1 is a strong danger sign that the company is headed for trouble. A ratio below 1 means the company is operating with
negative working capital;
in other words, its current debt obligations exceed the amount of money it has available to pay those debts.

A company also can have a current ratio that’s too high. Any ratio over 2

means the firm isn’t investing its assets well. The company can probably put some of those short-term assets to better use by investing them in growth opportunities.

However, many lenders and analysts believe that the current ratio isn’t a good enough test of a company’s debt-paying ability because it includes some assets that aren’t easy to turn into cash, such as inventory. A company must sell the inventory and collect the money before it has cash to work with, and doing so can take a lot more time than using cash that’s already on hand, or just collecting money due for accounts receivable, which represent customer accounts for items already purchased.

Determining the Quick Ratio

Stricter than the current ratio is a test called the
quick ratio
or
acid test ratio,
which measures a company’s ability to pay its bills without taking inventory into consideration. The calculation includes only cash on hand or cash already due from accounts receivable. Unlike the current ratio, the quick ratio doesn’t include money anticipated from the sale of inventory and the collection of money from those sales. To calculate this ratio, you use a two-step process: First, find the assets that a company can quickly turn into cash; then divide those quick assets by the current liabilities.