Reading Financial Reports for Dummies (33 page)

Calculating the quick ratio

Here’s the two-step process you use to find the quick ratio: 174
Part III: Analyzing the Numbers

1.
Determine the quick assets.

Quick assets = Cash + Accounts receivable + Short-term investments
2.
Calculate the quick ratio.

Quick assets ÷ Current liabilities = Quick ratio or acid test ratio Using information from Mattel’s and Hasbro’s balance sheets, I take you through the two-step process.
Note:
I added only two figures to find the quick assets for Mattel and Hasbro because both companies combine cash and short-term investments or marketable securities on their balance sheets.

Mattel

Quick assets = $901,148,000 + $991,196,000 = $1,892,344,000

$1,892,344,000 (Quick assets) ÷ $1,570,429,000 (Current liabilities) = 1.2

(Quick ratio)

So Mattel has $1.20 of quick assets for every $1 of current liabilities.

Hasbro

Quick assets = $774,458,000 + $654,789,000 = $1,429,247,000

$1,429,247,000 (Quick assets) ÷ $887,671,000 (Current liabilities) = 1.61

(Quick ratio)

So Hasbro has $1.61 of quick assets for every $1 of current liabilities.

Hasbro is in a better position than Mattel based on the quick ratio, but both companies have a quick ratio over 1, so they should have no problem paying their bills.

What do the numbers mean?

A company is usually considered to be in a good position as long as its quick ratio is over 1. A quick ratio below 1 is a sign that the company will likely have to sell some short-term investments to pay bills or take on additional debt until it sells more of its inventory.

If you’re looking at statements from companies in the retail sector, you’re more likely to see a quick ratio under 1. Retail stores often have a lot more money tied up in inventory than other types of businesses. As long as the company you’re evaluating is operating at or near the quick ratio of similar companies in the industry, you’re probably not looking at a problem situation, even if the quick ratio is under 1.

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Remember that a quick ratio of less than 1 can be a sign of trouble ahead if the company isn’t able to sell its inventory quickly. Other issues that can cause problems include slow-paying customers and accounts receivable that aren’t collected when billed. In Chapters 15 and 16, I take a closer look at how you can assess inventory and accounts-receivable turnover.

Investigating the Interest Coverage Ratio

Although the current and quick ratios look at a company’s ability to pay back creditors by comparing items on the balance sheet, the
interest coverage ratio
looks at income to determine whether the company is generating enough profits to pay its interest obligations. If the company doesn’t make its interest payments on time to creditors, its ability to get additional credit will be hurt, and eventually, if nonpayment goes on for a long time, the company could end up in bankruptcy.

The interest coverage ratio uses two figures that you can find on the company’s income statement: earnings before interest, taxes, depreciation, and amortization (also known as EBITDA; check out Chapter 7 for more information); and interest expense (also in Chapter 7).

Calculating the interest coverage ratio

Here’s the formula for finding the interest coverage ratio: EBITDA ÷ Interest expense = Interest coverage ratio

Calculating this ratio may or may not be a two-step process. Many companies include an EBITDA line item on their income statements. If a company hasn’t included this line item, you have to calculate EBITDA yourself.

Mattel and Hasbro don’t have an EBITDA line item, so I show you how to figure that out before you try to calculate the ratio.

Mattel

Mattel reports operating income before it lists its interest and tax expenses.

Mattel doesn’t have a line item for amortization or depreciation, so you need to look at the cash flow statement to find that amortization totaled $11,290,000 and depreciation totaled $160,790,000. Therefore, in Mattel’s case, EBITDA was $730,078,000 + $160,790,000 + $11,290,000 = $902,158,000.

Then, to get the interest coverage ratio:

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Part III: Analyzing the Numbers

$902,158,000 (EBITDA) ÷ $70,974,000 (Interest expense) = 12.71 (Interest coverage ratio)

Thus, Mattel generates $12.71 income for every $1 it pays out in interest.

Hasbro

Hasbro reports amortization expenses of $67,716,000 on the income statement (I talk more about amortization in Chapters 4 and 6). It also reports $88,804,000 for depreciation and amortization of plant and equipment on the statement of cash flows, so you need to add those expenses back in to find the EBITDA:

$519,350,000 (Operating income) + $67,716,000 (Amortization on income statement) + $88,804,000 (Depreciation and amortization of plant and equipment) = $675,870,000 (EBITDA)

And then:

$675,870,000 (EBITDA) ÷ $34,618,000 (Interest expense) = 19.52 (Interest coverage ratio)

Hasbro generates $19.52 for every $1 it pays out in interest.

What do the numbers mean?

Both companies clearly generate more than enough income to make their interest payments. A ratio of less than 1 means a company is generating less cash from operations than needed to pay all its interest.

Lenders believe that the higher the interest coverage ratio is the better. You should be concerned about a company’s fiscal health anytime you see an interest coverage ratio of less than 1.5. This means the company generates only about $1.50 for each $1 it pays out in interest. That’s operating on a tight budget. Any type of emergency or drop in sales could make it difficult for the company to make its interest payments.

Comparing Debt to Shareholders’ Equity

How a company finances its operations involves many crucial decisions.

When a firm uses debt to pay for new activities, it has to pay interest on that debt, plus pay back the principal amount at some point in the future. If a company uses shareholders’ equity (stock sold to investors) to finance new activities, it doesn’t need to make interest payments or pay back investors.

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Finding the right mix of debt and equity financing can have a major impact on a company’s cost of capital. Too much debt can be both risky and costly.

However, if a company has too high a level of equity, investors may believe that it isn’t properly leveraging its money.
Leverage
is the degree to which a business uses borrowed money. For example, a company typically buys a new building by using a combination of a mortgage (debt) and cash (from a new stock issue or retained earnings, which is the equity side of the equation). When a company uses leverage, its cash can go a lot further.

Suppose that you have $50,000 to pay for a home. This amount isn’t enough to buy the home you want, so you use that money as a deposit on the home and get a mortgage for the rest of the money due. If the house price is $250,000 and you put down $50,000, you can use the mortgage to leverage that cash so you can afford the home. In this scenario, the mortgage covers 80 percent of the purchase price. Any cash you earn beyond your monthly mortgage payment can be used to pay your other bills and buy food and other things you need or want.

As an investor, you want to know how a company allocates its debt versus its equity. To determine this, use the
debt to shareholders’ equity
(see the following section). You also want to check the company’s
debt-to-capital ratio
(see the upcoming section “Determining Debt-to-Capital Ratio”), which lenders use to determine how much they’ll lend and to monitor a company’s debt level.

Calculating debt to shareholders’ equity

To calculate debt to shareholders’ equity, divide the total liabilities by the shareholders’ equity. This ratio shows you what portion of a company’s capital assets is paid by debt and what portion is financed by equity.

Here’s the formula you use to calculate debt to shareholders’ equity: Total liabilities ÷ Shareholders’ equity = Debt to shareholders’ equity I use the numbers from Mattel’s and Hasbro’s 2007 balance sheets to show you how to calculate the debt to shareholders’ equity ratio.

Mattel

$2,498,713,000 (Total liabilities) ÷ $2,306,742,000 (Shareholders’ equity) =

1.08 (Debt to shareholders’ equity)

Mattel used $1.08 from creditors for every $1 it had from investors.

Therefore, Mattel depends a bit more on money raised by borrowing than on money raised by selling stock to investors.

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Part III: Analyzing the Numbers

Hasbro

$1,851,971,000 (Total liabilities) ÷ $1,385,092,000 (Shareholders’ equity) =

1.34 (Debt to shareholders’ equity)

Hasbro used $1.34 from creditors for every $1 it had from investors.

Therefore, Hasbro used a greater proportion of borrowed money from creditors to operate its company than Mattel did.

What do the numbers mean?

A debt to shareholders’ equity ratio that’s greater than 1 means that the company finances a majority of its activities with debt. A ratio under 1 means that the company depends more on using equity than debt to finance its activities.

In most industries, a 1:1 ratio is best, but it varies by industry. You can best judge how a company is doing by comparing it with similar companies and the industry averages.

As the ratio creeps higher and higher above 1, a firm’s finances get more risky, especially if interest rates are expected to rise. Alarm bells should sound when you see a company near or above 2. Lenders consider a business that carries a debt load this large a credit risk — which means the company will have to pay much higher interest rates to finance its capital activities.

Determining Debt-to-Capital Ratio

Lenders take another look at debt using the
debt-to-capital ratio,
which measures a company’s leverage by looking at what portion of its capital comes from debt financing.

Calculating the debt-to-capital ratio

You use a three-step process to calculate the debt-to-capital ratio:
1. Find the total debt.

Total debt = Short-term borrowing + Long-term debt + Current portion of long-term debt + Notes payable

2. Find the capital.

Capital = Total debt + Equity

3. Calculate the debt-to-capital ratio.

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Total debt ÷ Capital = Debt-to-capital ratio

To show you how to calculate the debt-to-capital ratio, I use the information from Mattel’s and Hasbro’s 2007 balance sheets.

Mattel

First, to find out Mattel’s total debt, add up Mattel’s short-term and long-term debt obligations:

Short-term borrowings

$349,003,000

Current portion of long-term debt

$50,000

Long-term debt

$550,000,000

Total debt

$949,003,000

Next, add the total debt to total equity to figure the number for capital: $2,306,742,000 (Equity) + $949,003,000 (Debt) = $3,255,745,000 (Capital) Finally, calculate the debt-to-capital ratio:

$949,003,000 (Total debt) ÷ $3,255,745,000 (Capital) = 0.29 (Debt-to-capital ratio)

So Mattel’s debt-to-capital ratio was 0.29 to 1 in 2007.

Hasbro

First, to find out Hasbro’s total debt, add up Hasbro’s short-term and long-term debt obligations:

Short-term borrowings

$10,201,000

Current portion of long-term debt

$135,348,000

Long-term debt

$709,723,000

Total debt

$855,272,000

Then add the total debt to total equity to find out the number for capital: $1,385,092,000 (Equity) + $855,272,000 (Debt) = $2,240,364,000 (Capital) Finally, calculate the debt-to-capital ratio:

$855,272,000 (Total debt) ÷ $2,240,364,000 (Capital) = 0.38 (Debt-to-capital ratio)

So Hasbro’s debt-to-capital ratio was higher than Mattel’s at 0.38 to 1.

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Part III: Analyzing the Numbers

What do the numbers mean?

Lenders often place debt-to-capital ratio requirements in the terms of a credit agreement for a company to maintain its credit status. If a company’s debt creeps above what its lenders allow for the debt-to-capital ratio, the lender can
call
the loan, which means the business has to raise cash to pay off the loan. Companies usually take care of a call by finding another lender. The new lender will likely charge higher interest rates because the company’s higher debt-to-capital ratio makes the company appear as though it’s a greater credit risk.

Generally, companies are considered to be in good financial shape with a debt-to-capital ratio of 0.35 to 1 or less. If a company’s debt-to-capital ratio creeps above 0.50 to 1, lenders usually consider the company a much higher credit risk, which means it has to pay higher interest rates to get loans.

Take note of the ratio and how it compares with the ratios of similar companies in its industry. If the company has a higher debt-to-capital ratio than most of its competitors, lenders will probably see it as a much higher credit risk.

A company with a higher than normal debt-to-capital ratio faces an increasing cost of operating as it tries to meet the obligations of paying higher interest rates. These higher interest payments can spiral into more significant problems as the cash crunch intensifies. In a worst-case scenario, the company can seek bankruptcy protection from its creditors to continue operating and to restructure its debt. Many times its stock value plummets and may have no value left at all if the company emerges from bankruptcy.

Chapter 13

Making Sure the Company

Has Cash to Carry On

In This Chapter

▶ Determining a company’s solvency

▶ Gauging financial strength by looking at debt

▶ Checking cash sufficiency

No business can operate without cash. Unfortunately, the balance sheet (see Chapter 6) and income statement (see Chapter 7) don’t tell you how well a company manages its cash flow, which is critical for measuring a company’s ability to stay in business. To find this important information, you need to turn to the
statement of cash flows
, also known as the
cash flow statement,
which looks at how cash flows into and out of a business through
its