Reading Financial Reports for Dummies (29 page)

to avoid counting revenue twice and giving the financial report reader the impression that the consolidated entity has more profits or owes more money than it actually does. Other key transactions that a parent company must eliminate when preparing consolidated financial statements are

✓

Investments in the subsidiary:
The parent company’s books show its investments in a subsidiary as an asset account. The subsidiary’s books show the stock that the parent company holds as shareholders’ equity.

Rather than double-counting this type of transaction, the parent company eliminates it on the consolidated statements by writing off one transaction.

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Advances to the subsidiary:
If a parent company advances money to a subsidiary or a subsidiary advances money to its parent company, both entities carry the opposite side of this transaction on their books (that is, one entity gains money while the other one loses it, or vice versa).

Again, companies avoid the double transaction on the consolidated statements by getting rid of one transaction.

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Interest revenue and expenses:
Sometimes a parent company loans money to a subsidiary or a subsidiary loans money to a parent company; in these business transactions, one company may charge the other one interest on the loan. On the consolidated statements, any interest revenue or expenses that these loans generate must be eliminated.

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Dividend revenue and expenses:
If a subsidiary declares a dividend, the parent company receives some of these dividends as revenue from the subsidiary. Anytime a parent company records revenue from its subsidiaries on its books, the parent company must eliminate any dividend expenses that the subsidiary recorded on its books.

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Management fees:
Sometimes a subsidiary pays its parent company a
management fee
for the administrative services it provides. These fees are recorded as revenue on the parent company’s books and as expenses on the subsidiary’s books.

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Sales and purchases:
Parent companies frequently buy products or materials from their subsidiaries, and their subsidiaries buy products or materials from them. In fact, most companies that buy other companies do so within the same industry as a means of getting control of a product line, a customer base, or some other aspect of that company’s operations.

However, the consolidated income statements shouldn’t show these sales as revenue and shouldn’t show the purchases as expenses.

Otherwise, the company would be double-counting the transaction.

Accounting rules require that parent companies eliminate these types of transactions.

As you can see, these major transactions are all critical for determining whether a company made a profit or loss from its activities. Eliminating assets, liabilities, revenue, and expenses from public view makes 148
Part II: Checking Out the Big Show: Annual Reports
determining a subsidiary’s financial results nearly impossible for shareholders or creditors. But if these transactions were included, the value of the parent company’s stock would be distorted because the transactions would be counted twice. The shareholders of the parent company wouldn’t know the true value of the company’s assets and liabilities; the income statement wouldn’t reflect the company’s true revenues and expenses.

The Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) tried to address the problem that shareholders and creditors of a subsidiary face by requiring parent companies to provide
segment reporting
(reporting about subsidiaries, business units, and divisions of the company), which you also find in the notes to the financial statements.

Looking to the Notes

The eliminations to adjust for reporting subsidiary results mentioned in the previous section don’t show up in the parent company’s financial reports unless some portion of the stock acquisition takes place in the year that’s being reported. When the acquisition or some financial impact of that acquisition does take place in the year that’s being reported, you need to look to the notes to the financial statements to get details about any financial impacts.

In the first note to the consolidated financial statement, the company indicates that the financial statements represent the results of the parent company,
not
its affiliates. The company also includes some statement about the eliminated transactions. Just to give you an example of how this is worded, here’s the information from GE’s notes:

“Financial data and related measurements are presented in the following
categories:

“*GE: This represents the adding together of all affiliates other than General
Electric Capital Services, Inc. (GECS), whose operations are presented on a
one-line basis.”

Note that you don’t find out what subsidiaries fall under GE in this explanation. You don’t find that detail in Mattel’s or Hasbro’s notes, either, as I discuss in Chapter 9. Few companies provide that detail. What GE does do that’s unique is show the results of GECS and indicate which subsidiaries fall under that subsidiary. Sound like a confusing house of cards? Yep, it sure is, which is what makes reading consolidated financial statements so difficult! Here’s what GE says about GECS:

“This affiliate owns all of the common stock of General Electric Capital
Corporation (GE Capital). GE Capital and its respective affiliates are
consolidated in the accompanying GECS columns and constitute the majority
of its business.”

Chapter 10: Considering Consolidated Financial Statements
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After reading that statement, you can see that the financial statements are as clear as mud if you want to determine how GE Capital or any of its subsidiaries are doing.

Mergers and acquisitions

If a company completes a merger or acquisition in the year that’s reported on the consolidated financial statement, you find a special note in the notes to the financial statements. Otherwise, if you want to find out any details about how the mergers and acquisitions may still be impacting the company financially, you have to start digging.

For example, if a company issues additional shares of stock to buy a subsidiary, the value of the stock held by shareholders before the acquisition is
diluted,
which means that the same earnings or assets must be divided among a greater number of pieces. To see how this works, imagine an example involving 100 shares of stock and a company profit of $100. In this scenario, each share of stock claims $1 of earnings. If, after the acquisition, 150 shares of stock are outstanding, each share of stock can claim only 67 cents of the $100

of earnings. This diluted ownership impacts the amount of dividends or the portion of ownership you have in the company for the rest of the time you own that stock.

You can see how you need to play a game of cat-and-mouse to find all the little pieces of cheese laid out in the financial statements. Companies don’t make information easily accessible, and they often hide the financial impact of an acquisition or merger on the value of your shares by writing the notes to the financial statements in such a convoluted way that you have to be a detective to sort out the relevant details.

Goodwill

Another important note you can check out to find the impact of mergers and acquisitions on the consolidated financial statements is the note that explains goodwill.
Goodwill
is the amount of money a company pays in excess of the value of the assets when it buys another company (see Chapters 4 and 6 for more details). For example, suppose a company has $100 million in assets, and another company offers to buy it for $150 million.

That extra $50 million doesn’t represent tangible assets like inventory or property; it represents extra value because of customer loyalty, store locations, or other factors that add value. Goodwill is a factor only in the case of a merger or acquisition that involves acquiring 100 percent of the subsidiary or other affiliate.

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Liquidations or discontinued operations

Whenever a company sells a subsidiary or other affiliate or discontinues its operations, a note to the financial statements regarding this transaction appears in the year in which the transaction first occurred. After the first year, any impact that a sale or a discontinuance of operations has on a company’s operating results is usually buried in other notes. Just like with mergers and acquisitions, you have to play detective to find out any ongoing impact that these changes have had on the company.

The company will include information in the notes about any profits or losses related to the liquidation of an asset or discontinued operations. Because these transactions can impact financial statements over a number of years, the fine print will include financial impacts for the years prior to the year being reported as well as anticipated future impacts.

When reading the consolidated financial statements and their related notes, be sure you look for any mention of the impact of previous mergers or acquisitions of affiliates and how those transactions may still be impacting the financial statements. You may find notes related to impacts on the balance sheet, income statement, shareholders’ equity, or cash flows. Transactions involving affiliates can impact any of these statements.

Part III

Analyzing the

Numbers

In this part . . .

I show you how to crack the numbers so you can find

out whether the company whose report you’re reading

is truly in a healthy financial position. I explain how to analyze the financial statements to test whether the company is profitable and liquid enough to continue operat-

ing. I also give you tips on how to test the company’s

cash-flow situation.

Chapter 11

Testing the Profits

and Market Value

In This Chapter

▶ Getting a handle on the price/earnings ratio

▶ Diving into the dividend payout ratio

▶ Examining return on sales

▶ Reviewing return on assets

▶ Understanding return on equity

▶ Working with margins

Well, did the company make any money? That’s the question everyone, and I mean
everyone
with a financial stake in the company —

executives, investors, debtors, employees — wants the answer to. Investors especially want to know whether the company’s stock is worth the price they have to pay.

You may think the answer is a simple “yes” or “no,” but the answer always depends on many factors. How well did the business make use of its resources in order to make a profit? Was that profit high enough based on the resources the firm had on hand and compared with that of similar companies? Did the company pay out a fair share of its earnings to its investors?

Did it reinvest the right amount of money in its coffers for future growth?

In this chapter, I show you how to answer these key questions with calculations that help you test a company’s profitability and market value: price/

earnings ratio (P/E), dividend payout ratio, return on sales (ROS), return on assets (ROA), and return on equity (ROE). I also review how to calculate the profit margins — both the operating margin and the net margin.

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Part III: Analyzing the Numbers

To help you understand the validity of these profitability tests, I compare the results of the two leading toy companies, Mattel and Hasbro, and I compare their results with those of the toy industry in general. If you want to follow along, you need the financial statements of Mattel (www.mattel.com) and Hasbro (www.hasbro.com). You can download those at each of the company’s Web sites or you can order an annual report by calling the company’s investor relations office.

The Price/Earnings Ratio

The profit number you hear discussed most often in the financial news is the
price/earnings ratio,
or the
P/E ratio.
Basically, the P/E ratio looks at the price of the stock versus its earnings. For example, a P/E ratio of 10 means that for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock. If the P/E is 20, that means people are willing to pay $20 per share for each $1 of company earnings.

Why are people willing to pay more per dollar of earnings on some stock?

Because the people who buy the more expensive stock believe the stock has greater potential for growth. This ratio is used when valuing stocks and is one of the oldest measurements in the world of stock exchanges.

On its own, the P/E ratio means very little, but as part of an overall evaluation of a company, the P/E ratio helps you interpret earnings results. Never make a decision about whether to buy or sell a stock based solely on the P/E ratio.

Nonetheless, a negative P/E or a P/E of zero is a major trouble sign, indicating that a company isn’t profitable.

Figuring out earnings per share