Reading Financial Reports for Dummies (24 page)

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Collectibility:
Some companies may indicate that whether they report income depends on whether all the revenue is likely to be collected.

Successful collection can depend on the business environment, a customer’s financial condition, historical collection experience, accounts receivable aging, and customer disputes. If collectibility is uncertain, the revenue isn’t reported. I talk more about accounts receivable collections and how to analyze them in Chapter 16.

Expenses

Expenses differ widely among companies. As you read this part of the accounting policies note, be sure to notice the types of expenses the company chooses to highlight. Sometimes the differences between companies can actually give you insight into how the companies operate. Here are two key areas where you may see differences in how a company reports expenses:

Chapter 9: Scouring the Notes to the Financial Statements
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Product development:
Some companies develop all their products in-house, whereas others pay royalties to inventors, designers, and others to develop and market new products. In-house product development is reported as research and development expenses. If the company develops new products primarily by using outside sources, these expenses are in a line item for royalty expenses.

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Advertising:
Some companies indicate that all advertising is expensed at the time the advertising is printed or aired. Others may write off advertising over a longer period of time. Companies that depend on catalog sales are likely to spread out their ad expenses over several months or even a year if they can prove that sales continued to come in during that longer period of time.

As you compare two firms’ financial reports, look for both the similarities and differences in their accounting policies. You may need to make some assumptions regarding the financial statements in order to compare apples to apples when trying to decide which company is the better investment. For example, if the companies depreciate assets differently, you must remember that their asset valuations aren’t the same, nor are their depreciation expenses (based on the same assumptions).

Sometimes you find a special note when a significant event impacts company operations. Such an event did occur for Mattel, and it’s reflected in a special note entitled “Note 4 — Product Recalls and Withdrawals.” During 2007, Mattel had several major recalls because of defective products manufactured in China. In response to these recalls, Mattel wrote:

As a result of third quarter 2007 recalls, Mattel intentionally slowed down
its shipments out of Asia while it conducted extensive product testing in the
third quarter 2007. Also, export licenses at several manufacturing facilities
in China were temporarily suspended in September 2007 while safety procedures were reviewed, but all licenses were in place on December 31, 2007.

Mattel’s ability to import products into certain countries was also temporarily impacted by product recalls as certain countries and regulatory authorities reviewed Mattel’s safety procedures; however, these import and export
issues were largely resolved early in the fourth quarter of 2007 and did not
have a significant financial impact on Mattel’s 2007 results.

Although Mattel states the recalls didn’t have a significant impact on its bottom line, costs to straighten out this mess legally and administratively totaled $42 million, according to Note 4. Product recalls cost the company another $68.4 million. Luckily for Mattel, the company was able to put a fix in place before its key fourth quarter sales period during the holiday season. Otherwise, some popular Mattel toys may not have been available for Christmas and Chanukah shoppers. But that $110.4 ($42 + $68.4) million equaled about 18 percent of Mattel’s net income of about $600 million, which to me seems like a significant impact.

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Figuring Out Financial Borrowings

and Other Commitments

How a company manages its debt is critical to its short- and long-term profitability. You can find out a lot about a company’s financial management by reading the notes related to financial commitments.

You always find at least one note about the financial borrowings and other commitments that impact the short- and long-term financial health of the company.

Mattel has one note that summarizes everything under one umbrella called

“Seasonal financing and long-term debt.” Hasbro splits this note into two. One is called “Financing arrangements,” for the short-term borrowings and other special arrangements, and the second is called “Long-term debt.”

No matter how a company structures its notes related to financial borrowings and other commitments, as you read the notes, break the information down into two piles: long-term borrowings and short-term borrowings. The
long-term
borrowings
involve financial obligations of more than one year, and the
short-term borrowings
involve obligations due within the 12-month period being discussed in the financial report.

Long-term obligations

For accounting purposes on the financial statements, only two types of debt are recognized: current debt and long-term debt.
Current debt
is due over the next 12 months, and
long-term debt
includes debt that a company must pay during any period beyond the next 12 months. Both medium- and long-term notes or bonds fall into the long-term debt category.
Medium-term notes or
bonds
are debt that a company borrows for two to ten years.
Long-term notes
or bonds
include all debt borrowed for over ten years.

In the discussion of long-term financial debts, you find two key charts. One chart shows the terms of the borrowings, and the other shows the amount of cash that the company must pay toward this debt for each of the next five years and beyond.

Table 9-1 shows Mattel’s long-term debt.

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Table 9-1

Mattel’s Long-term Debt

Long-term Debt

As of Year End 2007

As of Year End 2006

(in Thousands)

(in Thousands)

Medium-term notes (6.5%

$300.000

$350.000

to 7.49%, weighted average

7.11%) due from March 2008

to November 2013.

Senior notes (floating rate)

$300,000

$300,000

due June 2009 to June 2011

(6.125%)

Other

$0

$50,000

Less: Current portion (to be

($50,000)

($64,286)

paid in 2008)

Total long-term debt

$550,000

$635,714

If a company is managing its debt well, it will frequently be looking for opportunities to lower its interest expenses. Because interest rates have dropped considerably, when you see interest rates on these charts that are significantly higher than interest rates available in the current market environment, you should wonder whether the company is doing a good job of managing its debt.

Hasbro’s long-term debt information is shown in Table 9-2.

Table 9-2

Hasbro’s Long-term Debt

Long-term Debt

As of Year End 2007

As of Year End 2006

(in Thousands)

(in Thousands)

6.15% notes due 2008

$135,092

$135,092

6.3% notes due 2017

$350,000

$0

2.75% debentures due 2021

$249,828

$249,996

6.6% notes due 2028

$109,895

$109,895

Total notes due

$844,815

$494,983

(continued)

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Part II: Checking Out the Big Show: Annual Reports
Table 9-2
(continued)

Long-term Debt

As of Year End 2007

As of Year End 2006

(in Thousands)

(in Thousands)

Fair value adjustment for

$256

$(66)

interest rate swaps

Total long-term debt

$845,071

$494,917

Less: current portion

$135,348

$0

Long-term debt excluding

$709,723

$494,917

current portion

In 2003, Hasbro retired long-term debt with an interest rate of 8.5 percent by selling $250,000 of
senior convertible debentures
(a type of debt that can be converted to stock) with an interest rate of only 2.75 percent. Hasbro is still benefiting from this decision, and a large share of its long-term debt is still at this low rate. This interest rate can be adjusted upward, depending on the value of the company’s stock. These debentures are convertible to stock, but Hasbro indicates that it will buy back the debentures in cash rather than in shares of the company if a debenture holder indicates that she wants to convert the debenture.

You can compare the two companies’ debt obligations by looking at the installments due for the next five years and beyond. Table 9-3 compares the long-term debt payments for Hasbro and Mattel; this information is found in the note about financial borrowings and other commitments.

Table 9-3

Current Year Installments on Long-term

Debt of Hasbro and Mattel

Year Due

Hasbro’s Installments

Mattel’s Installments

on Long-term Debt (in

on Long-term Debt (in

Thousands)

Thousands)

2008

$135,092

$50,000

2009

$0

$150,000

2010

$0

$50,000

2011

$0

$250,000

2012

$0

$50,000

Thereafter

$709,723

$50,000

Total

$844,815

$600,000

Chapter 9: Scouring the Notes to the Financial Statements
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Looking at Table 9-3, you can see that Hasbro has only one payment on long-term debt of $135,092,000, with no payments due from 2009 to 2012 thanks to the debentures due in 2021. You can find out this information only by looking at the details in the notes. But Hasbro will still owe $709.7 million after 2012, and Mattel’s long-term debt will be paid off with one payment of $50 million in 2013.

I take a closer look at this issue and how it impacts the companies’ liquidity in Chapter 12. I also show you how potential lenders analyze a company’s borrowing habits.

Short-term debt

Short-term debt can have a greater impact than long-term debt on a company’s earnings each year, as well as on the amount of cash available for operations. The reason is that companies must pay short-term debt over the next 12 months, whereas for long-term debt, they must pay only interest and some of the principal in the next 12 months.

The type of short-term debt you see on a firm’s balance sheet varies greatly, depending on the type of business. Companies whose sales are seasonal may carry a lot more short-term debt to get themselves through the slow times than companies that have a consistent cash flow from sales throughout the year.

Seasonal companies carry large lines of credit to help them buy or produce their products during the off-season times so they can have enough product to sell during the high season. For example, a company that sells toys sells most of its product during the Christmas or other peak toy-selling seasons; during the other times of the year, it has very low sales. So Mattel and Hasbro — both toy companies with significant seasonal financing needs —

maintain large lines of credit to be ready for Christmas and peak toy-selling seasons.

Another way that firms raise cash if they don’t have enough on hand is to sell their accounts receivable (credit extended to customers). A company can sell the receivables to a bank or other financial institution and quickly get cash for immediate needs rather than wait for the customers to pay. I talk more about accounts receivable management in Chapter 16.

Be sure to look for a statement in the financial obligations notes that indicates how the company is meeting its cash needs and whether it’s having any difficulty meeting those needs. Some companies use “financial obligations” in the title of the note; others may have one note on short-term debt obligations and another on long-term debt obligations.

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Lease obligations

Rather than purchase plants, equipment, and facilities, many companies choose to lease them. You usually find at least one note to the financial statements that spells out a company’s lease obligations. Many analysts consider lease obligations to be just another type of debt financing that doesn’t have to be shown on the balance sheet. Whether the lease is shown on the balance sheet or in the notes depends on the type of lease:

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Capital leases:
These leases provide ownership at no cost or at a greatly reduced cost at the end of the lease. This type of lease is shown as a long-term debt obligation on the balance sheet.

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Operating leases:
These leases offer no ownership provisions or provisions that require a considerable amount of cash to purchase the leased item. This type of lease is mentioned in the notes to the financial statements but isn’t shown on the balance sheet as debt.

Companies that must constantly update certain types of equipment to avoid obsolescence use operating leases rather than capital leases. At the end of the lease period, the companies return the equipment and replace it by leasing new, updated equipment. Operating leases have the lowest monthly payments.

When reading the notes, be sure to look for an explanation of the types of leases the company has and what percentage of its fixed assets are under operating leases. Some high-tech companies have larger obligations in operating-lease payments than they do in long-term liabilities. When calculating
debt ratios
(ratios that show the proportion of debt versus the type of asset or equity being considered; I show you how to calculate debt ratios in Chapter 12), many analysts use at least two-thirds, and sometimes the entire amount, of these hidden operating-lease costs in their debt-measurement calculations to judge a company’s liquidity.