Introduction
The primary objective of the income statement is to report to investors how much money a business made or lost during a specific period of time. Years ago, it was referred to as the Profit and Loss (or P&L) statement, and has since evolved into the most well-known and widely used financial report on Wall Street. Many times, investors make decisions based entirely on the P&L report without consulting the balance sheet or cash flow statements (which, while a mistake, is a testament to how influential it is).
To an enterprising investor, the income statement reveals much more than a business' earnings. It can give important insights into how effectively management is controlling costs, how much is being spent on research and development, the total amount of taxes paid, and interest coverage. In a few short minutes, an investor or analyst can also calculate profit and operating margins to compare a company to its competitors.
As we progress through this series of investing lessons, you must remember John Burr William's basic truth that a business is only worth the profit that it will generate for its owners from now until doomsday, discounted back to the present, adjusted for inflation. The income statement is the "report card" of those earnings, which ultimately determine the price you should be willing to pay for a business.
Sit back in your chair, take out a copy of an annual report, and let's begin working through it. In the end, I think you'll be surprised by how much you've learned. As always, there will be quiz following the lesson; you should be able to pass without missing more than two questions.
Below is a sample income statement taken from Walt Disney's 2001 annual report.
It's important to note that not all income statements look alike, although they necessarily contain much of the same information. As we work our way through various income statements, you will inevitably find they are much simpler and comparable than may appear at first glance.
Total Revenue or Total Sales
The first line on any income statement is an entry called total revenue or total sales. This figure is the amount of money a business brought in during the time period covered by the income statement. It has nothing to do with profit. If you owned a pizza parlor and sold 10 pizzas for $10 each, you would record $100 of revenue regardless of your profit or loss.
The revenue figure is important because a business must bring in money to turn a profit. If a company has less revenue, all else being equal, it's going to make less money. For startup companies and new ventures that have yet to turn a profit, revenue can sometimes serve as a gauge of potential profitability in the future.
Many companies break revenue or sales up into categories to clarify how much was generated by each division. Clearly defined and separate revenues sources can make analyzing an income statement much easier. It allows more accurate predictions on future growth. Starbucks' 2001 income statement is an excellent example:
Starbucks Coffee
Consolidated Statement of Earnings - Excerpt
Page 29, 2001 Annual Report
In thousands except earnings per share
Fiscal year ended 30-Sep-01 1-Oct-00
Net Revenues
Retail $2,229,594 $1,823,607
Specialty 419,386 354,007
Total net revenues 2,648,980 2,177,614
Starbucks' sales come primarily from two sources: retail and specialty. In the annual report, management explains the difference between the two several pages before the income statement. "Retail" revenues refer to sales made at company-owned Starbucks stores across the world. Every time you walk in and order your favorite latte, you are adding $3-5 in revenue to the company's books. "Specialty" operations, on the other hand, are money the company brings in by sales to "wholesale accounts and licensees, royalty and license fee income and sales through its direct-to-consumer business". In other words, the specialty division includes money the business receives from coffee sales made directly to customers through its website or catalog, along with licensing fees generated by companies such as Barnes and Nobles, which pay for the right to operate Starbucks locations in their bookstores.
Cost of Revenue, Cost of Sales, Cost of Goods Sold (COGS)
Cost of goods sold (COGS for short) is the expense a company incurred in order to manufacture, create, or sell a product. It includes the purchase price of the raw material as well as the expenses of turning it into a product. Cost of goods sold is also known as cost of revenue or cost of sales.
Going back to our Pizza Parlor example, your cost of goods sold include the amount of money you spent purchasing items such as flour and tomato sauce.
Gross Profit
The gross profit is the total revenue subtracted by the cost of generating that revenue. It tells you how much money the business would have made if it didn't pay any other expenses such as salary, income taxes, etc. Gross Profit should be broken out and clearly labeled on the income statement. Here's the formula to calculate it yourself:
Total Revenue - Cost of Goods Sold (COGS) = Gross Profit
The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss in a moment.
Gross Profit Margin
Although we are only a few lines into the income statement, we can already calculate our first ratio. The gross profit margin is a measurement of a company's manufacturing and distribution efficiency. A company that boasts a higher percentage than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors.
To calculate gross margin, use this formula:
Gross Profit
----------(divided by)----------
Total Revenue
For illustration purposes, let's calculate the gross margin of Greenwich Golf Supply (a fictional company).
Greenwich Golf Supply
Consolidated Statement of Earnings - Excerpt
In thousands except earnings per share
Fiscal year ended 30-Sep-01 1-Oct-00
Total Revenue $405,209 $315,000
Cost of Sales $243,125 $189,000
Gross Profit $162,084 $126,000
Assume the average golf supply company has a gross margin of 30%. [You can find this sort of industry-wide information in various financial publications, online finance sites such as moneycentral.com, or rating agencies such as Standard and Poors].
We can take the numbers from Greenwich Golf Supply's income statement and plug them into our formula:
$162,084 gross profit
----------(divided by)----------
$405,209 total revenue
The answer, .40 [or 40%], tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.
The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned. For more information on warning signs of accounting fraud, I recommend Howard Schilit's Financial Shenanigans: 2nd edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports
Putting It Together Thus Far:
We've actually covered a lot of ground. Here's an example to help reiterate and / or clarify everything we've discussed.
If the owner of an ice cream parlor purchased 10 gallons of vanilla ice cream for $2 per gallon, and sold each of those gallons to her customers for $5, the first three lines on her income statement would look something like this:
Total Revenue $50
(The total revenue is the amount of money rung up at the cash register. The owner sold 10 gallons of vanilla ice cream to her customers for $5 per gallon. 10 gallons x $5 a gallon = $50.)
Cost of Revenue $20
(The cost of goods sold was 10 gallons x $2 per gallon = $20)
Gross Profit $30
(The total revenue subtracted by the cost to earn that revenue is $30. Before taxes, and other expenses, this is the ice cream parlor's gross profit.)
Gross Margin: .6 (or 60%)
Operating Expenses
The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expenses consist of salaries paid to employees, research and development costs, and other misc. charges that must be subtracted from the company's income. As an investor / owner, you want to work with managements that strive to keep operating expenses as low as possible while not damaging the underlying business.
Research and Development
R&D costs can range from nothing to billions of dollars, depending upon the type of business you are analyzing. Unlike many other costs (such as income taxes), management is almost entirely free to decide how should be spent. In 2001, Eli Lilly, one of the world's largest pharmaceutical companies, plowed nearly 26% of the total gross profit back into R&D.
How much should a company spend on R&D? It depends. In highly creative and fast-moving industries, the amount of money spent on the research and development budget can literally determine the future of the business. If Eli Lilly stopped funding the development of new drugs, its future profitability would suffer, causing a perhaps permanent decline in earnings. In such cases, it may be appropriate to compare the level of R&D funding to profitability over time, as well as to the percentage of gross profit competitors spend on research and development.
Selling General and Administrative Expenses (SG&A)
SG&A expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. High SG&A expenses can be a serious problem for almost any business. A good management will often attempt to keep SG&A expenses limited to a certain percentage of revenue. This can be accomplished through cost-cutting initiatives and employee lay-offs.
There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit. In the 1980's, ABC (later merged with CAP Cities, then bought by Disney) was spending $60,000 a year on florists, as well as providing stretch limos and private dining rooms for its executives. It was the shareholders who were footing the bill. [On a related note: at the same time these ABC executives were squandering shareholders' capital, they were artificially padding earnings by selling original Jackson Pollack and Willem de Kooning paintings the network owned!]
Goodwill and other Intangible Asset Amortization Charges
In the past, companies were required to charge a portion of goodwill to the income statement, reducing reported earnings. For all good purposes, these charges were ignored by the investor. In June 2001, the Financial Accounting Standards Board (FASB) [the folks who make accounting rules in the United States], changed the guidelines, no longer requiring companies to take these amortization charges. If the company, through cash-flow analysis and other means, determines that the goodwill is impaired [meaning it's not worth the value it's carried at on the balance sheet], management will announce a write-down and reducing the carrying value of the goodwill. Intangible assets that do not have indefinite lives [such as patents] will continue to be amortized.
The complexities of goodwill were explained in detail in the Goodwill section of Lesson 3: Part 23.
Non-Recurring and Extraordinary Items or Events
In the unpredictable world of business, events will arise that are not expected and most likely not occur again. These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. This allows investors to more accurately predict future earnings. If, for instance, you were considering purchasing a gas station, you would base your valuation on the earning power of the business, ignoring one-time costs such as replacing the station's windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for $17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future.
What is the difference between non-recurring and extraordinary events? A nonrecurring charge is a one-time charge that the company doesn't expect to encounter again. An extraordinary item is an event that materially* affected a company's finance and needs to be thoroughly explained in the annual report or SEC filings. Extraordinary events can include costs associated with a merger, or the expense of implementing a new production system [as McDonald's did in the late 1990's with the Made for You food preparation system].
Non-recurring items are recorded under operating expenses, while extraordinary items are listed after the net line, after-tax.
*The term material is not specific. It generally refers to anything that affects a company in a meaningful and significant way. Some investors try to put a number on the figure, saying an event is material if it causes a change of 5% or more in the company's finances.
Accounting for Extraordinary and Non-Recurring Items or Events in Your Analysis
When calculating a company's earning-power, it is best to leave one-time events out of the equation. These events are not expected to repeat in the future, and doing so will give you a better idea of the earning power of the company.
If you are attempting to measure how profitable a business has been over a longer period, say five or ten years, you should average in the one-time events to paint a more accurate picture. For example, if a company purchased a building for $1 in 1990, and sold it for $10 ten years later in 2000, it is improper to consider the company earned $10 extra in the year 2000. Instead, the extraordinary income [in this case, $10], should be divided by the number of years it accrued [10 years - 1990 to 2000]. $10 extraordinary income divided by 10 years = $1 a year.
Although the income statement will reflect a $10 one-time profit for the business, the investor should restate the earnings during their analysis by going back and adding $1 to each of the years between 1990 and 2000. This will increase the accuracy of a trend line. Since the asset was quietly appreciating during this time, it should be reflected.
Operating Income
Operating income, or operating profit, is a measurement of the money a company generated from its own operations [it doesn't include income from investments in other businesses, for instance]. Operating income can be used to gauge the general health of the core business or businesses.
Operating Income = gross profit - operating expenses
The operating income figure is tremendously important because it is required to calculate the interest coverage ratio and the operating margin
Operating Margin [or Operating Profit Margin]
The operating margin is another measurement of management's efficiency. It compares the quality of a company's operations to its competitors. A business that has a higher operating margin than its industry's average tends to have lower fixed costs and a better gross margin, which gives management more flexibility in determining prices. This pricing flexibility provides an added measure of safety during tough economic times.
To calculate the operating margin, divide operating income by the total revenue.
Operating income
----------(divided by)----------
Total revenue
Interest Income
Companies sometimes keep their cash hoards in short-term deposit investments [such as certificates or deposit with maturities up to twelve months, savings account, and money market funds]. The cash placed in these accounts earn interest for the business, which is recorded on the income statement as interest income.
Interest income will fluctuate each year with the amount of cash a company keeps on hand.
Interest Expense
Companies often borrow money in order to build plants or offices, buy other businesses, purchase inventory, or fund day-to-day operations. The borrowed money is converted to an asset on the balance sheet (i.e., if a business borrows $1 million to build a distribution center, the distribution center would add $1 million of assets to the balance sheet after the cash was spent.) The interest a company pays to bondholders, banks, and private lenders, on the other hand, is an expense that it receives no asset for. Hence, interest expense must be accounted for on the income statement.
Some income statements report interest income and interest expense separately, while others report interest expense as "net". Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. [In other words, if a company paid $20 in interest on its bank loans, and earned $5 in interest from its savings account, the income statement would only show interest expense - net $15.]
The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.
Interest Coverage Ratio
The interest coverage ratio is a measurement of the number of times a company could make its interest payments with its earnings before interest and taxes; the lower the ratio, the higher the company's debt burden.
Interest coverage is the equivalent of a person taking the combined interest expense from their mortgage, credit cards, auto and education loans, and calculating the number of times they can pay it with their annual pre-tax income. For bond holders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company's earnings can fall before it will start defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business.
To calculate the interest coverage ratio, divide EBIT (earnings before interest and taxes) by the total interest expense.
EBIT (earnings before interest and taxes)
-----------------------(divided by)-----------------------
Interest Expense
As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. A ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company's earnings, the lower the interest coverage ratio can be.
EBIT has its short fallings; companies do pay taxes, therefore it is misleading to act as if they didn't. A wise and conservative investor would simply take the company's earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety.
Depreciation and Amortization
There are two different kinds of "depreciation" an investor must grapple with when analyzing financial statements, accumulated depreciation and depreciation expense. They are entirely different things, and are often confused with one another. In order to understand them, we must discuss them individually.
Depreciation Expense
According to Ameritrade, "Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. [emphasis added] Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred."
To help you understand the concept, let's look at an example:
Sherry's Cotton Candy Co., earns $10,000 profit a year. In the middle of 2002, the business purchases a $7,500 cotton candy machine that is expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 [$10k profit - $7.5k expense for purchasing the new machinery]. The investor would wonder why the profits had fallen so much during the year.
Thankfully, Sherry's accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five [$7,500 / 5 years = $1,500 per year]. Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of how the company's earning power. The practice of spreading-out the cost of the asset over its useful life is "depreciation expense".
This presents an interesting dilemma; although the company reported earnings of $8500 in the first year, it was still forced to write a $7,500 check [effectively leaving it with $2500 in the bank at the end of the year [$10,000 profit - $7,500 cost of machine = $2,500 left over]. This means that the cash flow of the company is actually different from what it is reporting in earnings. The cash-flow is very important to investors because they need to be ensured that the company can pay its bills on time. The first year, Sherry's would report earnings of $8,500, but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500, but have $10,000 in the bank since, in reality, the business paid for the machinery up-front in a lump-sum. Hence, if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.*
This is where the third major financial report, the Cash Flow Statement, is important. The cash flow statement is like a company's checking account. It shows how much cash was spent, at what time, and where. That way, an investor could look at the income statement of Sherry's Cotton Candy Co. and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing Lesson 5.
Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company's profits because it requires no immediate cash outlay. In other words, Sherry wasn't really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect. Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company's earning power. An investor who ignores the economic reality of depreciation will be apt to overvalue a business and find his or her returns lacking.
*Depreciation expenses are deductible; Sherry's would only pay taxes on $8,500 each year, spreading out her tax burden to the future. Some investors assume incorrectly that the business would pay taxes on $2,500 the first year and the full $10,000 each year after.
Accumulated Depreciation
If you purchased a new car for $50,000 and resold it three years later for $30,000, you would have experienced $20,000 loss on the value of your asset. This $20,000 is due to a force called depreciation. Accumulated depreciation is the reduction of the carrying amount of the assets on the balance sheet to reflect the loss of value due to wear, tear, and usage. Companies purchase assets such as computers, copy machines, buildings, and furniture, all of which lose value each day. This depreciation loss must be accounted for in the company's financial statements in order to give shareholders the most accurate portrayal of the economic realty of the business.
When you look at a balance sheet, if you see the entry "Property, Plant, and Equipment - net" it is referring to the fact that the company has deducted accumulated depreciation from the figure presented. To see the amount of those depreciation charges, you will probably have to delve into the annual report or 10k.
Straight Line Depreciation Method
The simplest and most commonly used, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset subtracted by the salvage value divided by the total productive years the asset can be reasonably expected to benefit the company [called "useful life" in accounting jargon].
purchase price of asset - approximate salvage value
-------------------------- (divided by) --------------------------
estimated useful life of asset
Example: You buy a new computer for your business costing approximately $5,000. You expect a salvage value of $200 selling parts when you dispose of it. Accounting rules allow a maximum useful life of five years for computers; in the past, your business has upgraded its hardware every three years, so you think this is a more realistic estimate of useful life, since you are apt to dispose of the computer at that time. Using that information, you would plug it into the formula:
$5,000 purchase price - $200 approximate salvage value
-------------------------- (divided by) --------------------------
3 years estimated useful life
The answer, $1,600, is the depreciation charges your business would take annually if you were using the straight line method.
Accelerated Depreciation Methods
Another way of accounting for depreciation is to use one of the accelerated methods. These include the Sum of the Year's Digits and the Declining Balance [either 150 or 200%] methods. These accelerated methods are more conservative and, in most cases, accurate. They assume that an asset loses a majority of its value in the first several years of use.
Sum of the Years Digits
To calculate depreciation charges using the sum of the year's digits method, take the expected life of an asset (in years) count back to one and add the figures together. Example:
10 years useful life = 10 + 9 + 8 + 7 + 6 +5 + 4 + 3 + 2 + 1 Sum of the years = 55
In the first year, the asset would be depreciated 10/55 in value [the fraction 10/55 is equal to 18.18%] the first year, 9/55 [16.36%] the second year, 8/55 [14.54%] the third year, and so on. Going back to our example from the straight-line discussion: a $5,000 computer with a $200 salvage value and 3 years useful life would be calculated as follows:
3 years useful life = 3 + 2 + 1 Sum of the years = 6
Taking $5,000 - $200 we have a depreciable base of $4,800. In the first year, the computer would be depreciated by 3/6ths [50%], the second year, by 2/6 [33.33%] and the third and final year by the remaining 1/6 [16.67%]. This would have translated into depreciation charges of $2,400 the first year, $1,599.84 the second year, and $800.16 the third year. The straight-line example would have simply charged $1,600 each year, distributed evenly over the three years useful life.
Double Declining Balance Depreciation
The double declining balance depreciation method is like the straight-line method on steroids. To use it, accountants first calculate depreciation as if they were using the straight line method. They then figure out the total percentage of the asset that is depreciated the first year and double it. Each subsequent year, that same percentage is multiplied by the remaining balance to be depreciated. At some point, the value will be lower than the straight-line charge, at which point, the double declining method will be scrapped and straight line used for the remainder of the asset's life [got all that?]. An illustration may help.
In our straight-line example, we calculated that a $5,000 computer with a $200 salvage value and an estimated useful life of three years would be depreciated by $1,600 annually. The first year, we have to compare this to the total amount to be depreciated, in this case, $4,800 [$5,000 base - $200 salvage value = $4,800]. Dividing $1,600 by $4,800, we discover the straight-line depreciation charge [$1,600] is 33.33% of the total depreciation amount [$4,800]. Using this information, we double the 33.33% figure to 66.67%.
In the first year, we would take $4,800 multiplied by .6667 to get a total depreciation charge of approximately $3,200. In the second year, we would take the same percentage [66.67%] and multiply it by the remaining amount to be depreciated. Continuing with the example, we find that $1,600 is the remaining amount to be depreciated at the start of the second year [$4,800 - $3,200 = $1,600]. Multiply 1,600 by .6667 to get $1,066. This is the depreciation charge for the second year - or not! Remember that once the depreciation charges dip below the amount that would be charged using the straight-line method, the double declining balance is scrapped and straight line immediately utilized. The straight line method called for charges of $1,600 per year. Obviously, the $1,066 charge is smaller than the $1,600 that would have occurred under straight line. Thus, the deprecation charge for the second year would be $1,600.
For those of you who love algebra, you may find it easier to use this equation:
depreciable base * (2 * 100% / useful life in years)
Comparing Depreciation Methods
Just to reinforce what we've learnt thus far, here's a look at what the depreciation charges for the same $5,000 computer would look like depending upon the method used.
Comparing Depreciation Methods
Method Year 1 Year 2 Year 3
Straight Line $1,600 $1,600 $1,600
Sum of the Years $2,400 $1,599.84 $800.16
Double Declining Balance $3,200 $1,600 $0
Obviously, depending upon which method is used by management, the bottom-line of a company can be seriously affected. The level of attention an investor must give depreciation depends upon the asset intensity of the business he or she is studying. The more asset-intensive an enterprise, the more attention depreciation should be given.
If you have two asset intensive businesses, and they are using different depreciation methods, and / or useful lives, you must adjust them so they are on a comparable basis in order to get an accurate picture of how they stack up against each other in terms of profit.
Some managements will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through SG&A expenses [for the deprecation costs of desks, for instance]. Either way, you should be able to garner the information either through the income statement itself or going through the annual report or 10k.
In Security Analysis [the classic 1934 edition], Benjamin Graham recommended the investor answer three questions when dealing with the effects of deprecation on a business [paraphrased]:
1. Is depreciation reflected in the earnings statement?
2. Is management using conservative and [as much as possible] accurate depreciation rates? Accounting rules allow assets to be written off over a considerable time period. Buildings, for example, can be depreciated anywhere from ten to thirty years, resulting in large differences in charges depending upon the time frame a particular business uses. A company's 10k filing should contain information on the rates employed by the company.
3. Are the cost or base to which the depreciation rates applied reasonable accurate? A company may set unrealistic salvage values on its assets, thus reducing the amount of depreciation charges it must take every year.
Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA
EBITDA tells an investor how much money a company would have made if it didn't have to pay interest on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company's financial performance, not free cash flow as many investor incorrectly assume, originally coming into existence in the 1980's during the leveraged-buyout frenzy that epitomized the era of greed. The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.
In its brilliance, Wall Street regrettably forgot one part of the equation: common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these expenses like they don't exist is the same mentality of the five year old who believes no one can see them when their eyes are closed - while they may enjoy pretending for a while, the IRS and the banks and bondholders who lent money to the company aren't interested in playing games. When the bills come due, these entities want the money owed to them and can force bankruptcy if they aren't paid.
Still not convinced? Picture this scenario:
A man making $100,000 annually walks into his local bank to get a loan on a new BMW. He pays an annual taxes of about $30,000, leaving his take-home pay at $1346.15 per week [for simplicity sake, let's ignore payroll deductions, etc.] He currently has a mortgage payment of $750 a month, and student loan payments of $250 a month. After paying out this $1,000 each month, he is left with $346.15 to live on
The loan officer crunches the numbers and comes up with an estimated monthly payment of $400 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. "Sir," she says, "you only make $346.15 a month after payments and taxes! You can't afford this loan. Not only can you not afford the payment, you will then have nothing to live on." The man looks confused, "but I make $1,346.15 per month before my payments and taxes."
See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely aren't. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.
The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can't make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn't be attained, they created a new one that made them appear successful.
In the accounting and business world, EBITDA is a firestorm of controversy. There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn't worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don't worry about it - four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it's folly such as this that presents us with opportunity to profit in the market.
If you are interested, there is an excellent article at the Motley Fool's website called The Limits of EBITDA. I highly recommend it.
Additional information:
10 Critical Failing of EBITDA - Computer World
EBITDA: The Good, the Bad, and The Ugly - Investopedia
Ignore EBITDA - The Motley Fool
What is EBITDA - The Motley Fool
Income before Tax
After deducting interest payments and [depending on the business] other expenses, the analyst / investor is left with the profit a company made before paying its income tax bill. It allows you to see what the business would have earned if it did not have to pay taxes to the government.
Income Tax Expense
The income tax expense is the total amount the company paid in taxes. This figure is frequently broken out by source [federal, state, etc.] either on the income statement or somewhere in the annual report or 10k.
You should be fairly familiar with the tax laws affecting specific companies and / or business transactions. For instance, say the business you were analyzing just purchased $100 million worth of preferred stock that was paying a 9% yield [we'll talk more about preferred stock later]. You could rightly assume the company would receive $9 million a year in dividends on the preferred. If the company had a tax rate of, say, 35%, you may assume that $3.15 million of these dividends are going to be paid to the Uncle Sam. In truth, corporations get an exemption on 70% of the dividends they receive from preferred stock [individuals do not enjoy this luxury]. Hence, only $2.7 million of the $9 million in dividends would be subject to taxation. Don't you love this stuff?
For your reference, here is a list of the corporate tax brackets from smbiz.com. It would serve you well to memorize them:
Corporate Income Tax Rates--2002, 2001, 2000, 1999, & 1998
Taxable income over Not over Tax rate
$ 0 $ 50,000 15%
50,000 75,000 25%
75,000 100,000 34%
100,000 335,000 39%
335,000 10,000,000 34%
10,000,000 15,000,000 35%
15,000,000 18,333,333 38%
18,333,333 .......... 35%
Minority Interests on the Income Statement
If Federated Department Stores [the owner of Macy's and Bloomingdales] purchased five percent of Saks Fifth Avenue, Inc., common sense tells us that Federated would be entitled to five percent of Saks' earnings. How would Federated report their share of Saks' earnings on their income statement? It depends on the percentage of the company's voting stock Federated owned.
* Cost Method (If Federated owned 20% or less):
The company would not be able to report its share of Saks' earnings, except for the dividends it received from the Saks stock. The asset value of the investment would be reported at the lower of cost or market value on the balance sheet. What does that mean?
If Federated purchased 10 million shares of Saks stock at $5 per share [for a total cost of $50 million], it would record any dividends received on its income statement, and add $50 million to the balance sheet under investments. If Saks rose to $10 per share, the 10 million shares would be worth $100 million [$10 per share x 10 million shares = $100 million]. However, the balance sheet would continue to list the 'value' of those 10 million shares at $50 million.
On the other hand, if the stock dropped to $2.50 per share, thus reducing the investments to $25 million, the balance sheet value would be written down to reflect the lower price.
* Equity Method (If Federated owned 21-49%):
In most cases, Federated would include a single-entry line on their income statement reporting their share of Saks' earnings. For example, if Saks earned $100 million and Federated owned 30 percent, they would include a line on the income statement for $30 million in income [30% of $100 million], even if these earnings were never paid out as dividends [meaning they never actually saw $30 million].
* Consolidated Method (If Federated owned 50+%):
The company would be required to include all of the revenues, expenses, tax liabilities, and profits of Saks on the income statement. It would then include an entry that deducted the percentage of the business it didn't own. If Federated owned 65% of Saks, it would report the entire $100 million in profit, and then include an entry labeled minority interest that deducted the $35 million [35%] of the profits it didn't own.
The Importance of Unreported or Look Through Earnings
You'll notice that the cost method, which applies to holdings under 20%, only allows the company to report the cash it actually receives in the form of dividends as income. This can be misleading. If your company owned 15% of Microsoft, you would never see a dime in dividends, although your 15% share of the earnings was being reinvested in the business on your behalf by management. Those earnings will subsequently lead to long-term rise in the value of your stock holding, and are therefore very important to your economic future.
Don't believe it? Say you inherit a business that your great-grandfather founded a century ago. At the end of every year, he used some of the business' profits to buy shares of Thomas Edison's company, General Electric. By the time the company came under your control in 2002, it owned 19% of GE's common stock [1,888,600,000 shares]. General Electric paid a dividend that year of $0.72 per share. According to GAAP accounting rules, your business could only report the $1,359,792,000 in dividends you received.
However, the year before, General Electric had actually made a profit of $14.6 billion, of which, nineteen percent indirectly belonged to you. Although you could only report $1.36 billion in dividends, you actually have a legal ownership to $2.774 billion in the company's earnings ($1.36 billion were paid out to you as dividends, with the remaining $1.4 billion retained by GE). This means that you were not allowed to report more than $1.4 billion in earnings that indirectly belonged to you. The general logic states that because you never see that money, it shouldn't count as income. This is both misinformed and dangerous. The entire $2.774 billion belongs to you. The portion of the earnings that were not paid out will be reinvested into GE's business and subsequently result in a rise in the stock price. If someone were to value the business, they would include the entire $2.774 billion in their calculation because the entire amount was working to your economic benefit.
Famed investor Warren Buffett referred to these unreported profits as look-through earnings. The successful investor strives to put together a portfolio with the highest possible look-through earnings for each dollar invested. This will result in market-beating returns. In his 1980 Letter to Shareholders of Berkshire Hathaway, Buffett explained that Berkshire's income statement was reporting less than half of what the company's true economic earnings were:
"Our holdings in this [20% or less] category of companies [has] increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly attractive opportunities in the common stock area. The large increase in such holdings, plus the growth of earnings experienced by those partially-owned companies, has produced an unusual result; the part of 'our' earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings "iceberg" to appear above the surface, in plain view."
Thus, you must add the non-reportable earnings of a company's partially owned businesses back into the income statement to come up with an accurate estimate of economic earnings.
Continuing / Ongoing Operations vs. Discontinued Operations
In the 1990's, Viacom, owner of MTV, VH1, and Nickelodeon, purchased Paramount Studios. To pay for the acquisition, Viacom took on a large amount of debt. The company's Chairman, Sumner Redstone, began selling assets and businesses the company owned in order to help pay down debt.
Simon & Schuster, a major book publisher, was one of the businesses Viacom decided to let go, ultimately selling it to British media group Pearson PLC for $4.6 billion dollars. How did the deal affect the company's revenue and earnings?
This is where discontinued and ongoing operations come to the rescue. As soon as Viacom sold Simon, it had a pile of cash from the buyer. However, it lost all of the revenue and profit the publisher generated. Viacom's management must somehow warn investors, "Hey, Simon generated [X amount] of our profit and revenue. Since we no longer own the business, you can't plan on us earning this revenue / profit next year". To do that, the Viacom puts an entry on their income statement called "Discontinued Operations". This shows investors money that was earned from businesses that won't be part of the company's holdings for very much longer.
Continuing operations are the businesses the company expects to be engaged in for the foreseeable future.
Net Income from Continuing Operations
After all of these expenses are deducted, the investor is left with a figure called net income from continuing operations. This is a calculation of the profit its continuing operations generated during the period.
Net Income from Discontinued Operations
The amount shown on the income statement under discontinued operations is the profit made during the period from the businesses that will not be a part of the company in the future.
Accounting Changes
GAAP accounting rules give management a large amount of leeway in determining how to report their earnings to shareholders. At times, a company may opt to change the way it has accounted for a particular item in the past, which will have the affect of increasing or decreasing the amount of reportable earnings although the company has not actually made or lost more money.
Management is required to disclose accounting changes in SEC filings. It is tremendously important that you determine if the change was necessary or simply a maneuver to inflate the amount of profit reported to shareholders.
Net Income
The net income is the total profit the business made for the period before required dividend payments on the company's preferred stock.
Preferred Stock and Other Adjustments
Preferred stock is a mix between regular common stock and a bond. Each share of preferred stock is normally paid a guaranteed, relatively high dividend and has first dibs over common stock at the company's assets in the event of bankruptcy. In exchange for the higher income and safety, preferred shareholders miss out on large potential capital gains [or losses]. Owners of preferred stock generally do not have voting privileges.
The terms of preferred shares can vary widely, even when issued by the same company. Some of the many different kinds of preferred stock available are: adjustable rate preferred stock, convertible preferred stock, first preferred stock, participating preferred stock, participating convertible preferred stock, prior preferred stock, and second preferred stock. [For more information, read the remainder of 09/16/02 article Preferred Stock and Individual Investors].
The dividends paid to preferred shares are deducted as an expense because they are required payments, unlike the common stock dividend which is just a divvying-up part of the profits.
Net Income Applicable to Common Shares
The net income applicable to common shares figure is the bottom-line profit the company reported. To get the basic earnings-per-share [Basic EPS] figure, analysts divide the net income applicable to common by the total number of shares outstanding.
The last line, at the bottom of the income statement is the amount of money the company purports to have made (net income, total profit, or reportable earnings; it's all the same). Hence the cliché, "what's the bottom line?"
Net Profit Margin
The profit margin tells you how much profit a company makes for every $1 it generates in revenue. Profit margins vary by industry, but all else being equal, the higher a company's profit margin compared to its competitors, the better. Several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales. While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation, to give an idea of how much money the company made before paying out to minority "owners". Either way is acceptable, although you must be consistent in your calculations. All companies must be compared on the same basis.
Option 1: Net income after taxes
-------------------------- (divided by) --------------------------
Revenue
Option 2: Net income + minority interest + tax-adjusted interest
-------------------------- (divided by) --------------------------
Revenue
In some cases, lower profit margins represent a pricing strategy. Some businesses, especially retailers, may be known for their low-cost, high-volume approach. In other cases, a low net profit margin may represent a price war which is lowering profits, as was the case in the computer industry in 2000.
Net Profit Margin Example
In 2002, Donna Manufacturing sold 100,000 widgets for $5 each, with a COGS of $2 each. It had $150,000 in operating expenses, and paid $52,500 in taxes. What is the net profit margin?
First, we need to find the revenue or total sales. If Donna's sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The company's cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs. This leaves a gross profit of $300,000 [$500k revenue - $200k COGS]. Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes. Subtracting the tax bill of $52,500, we are left with a net profit of $97,500.
Plugging this information into our formula, we get:
$97,500 net profit
--------------(divided by)--------------
$500,000 revenue
The answer, 0.195 [or 19.5%], is the net profit margin. Keep in mind, when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you; your only job is to plug them into the formula. [Why then did I make you go to all the work? I just wanted to make sure you've retained everything we've talked about thus far!]
Cherry Pie: Basic vs. Diluted Earnings per Share
When you analyze a company, you have to do it on two levels, the "whole company" and the "per share". If you decide ABC, Inc. is worth $5 billion as a whole, you should be able to break it down by simply dividing the $5 billion price tag by the number of shares outstanding. Unfortunately, it isn't always that simple.
Think of each business you analyze as a cherry pie and each share of stock as a piece of that pie. All of the company's assets, liabilities, and profits are represented by the pie as a whole. ABC's pie is worth $5 billion. If the baker [management] slices the pie into 5 pieces, each piece would be worth $1 billion [$5 billion pie divided into 5 pieces = $1 billion per slice]. Obviously, any intelligent connoisseur of pastries would want to keep the baker from making too many slices so his or her piece was as big as possible. Likewise, an ambitious investor hungry for returns is going to want to keep the company from increasing the number of shares outstanding. Every new share management issues decreases the investor's "piece" of the assets and profits a tiny bit. Over time, this can make a huge difference in how much the investor gets to eat.
"How can management increase the number of shares outstanding?" you may ask. There are four big knives [perhaps "cleavers" would be a more appropriate term] in any management's drawer that can be used to add increase the number of shares outstanding: stock options, warrants, convertible preferred stock, and secondary equity offerings [all sound more complicated than they are]. Stock options are a form of compensation that management often gives to executives, managers, and in some cases, regular employees. These options give the holder the right to buy a certain number of shares by a specific date at a specific price. If the shares are "exercised" the company issues new stock. Likewise, the other three cleavers have the same affect - the potential to increase the number of shares outstanding.
This situation leaves Wall Street with the problem of how much to report for the earnings per share figure. In response, they came up with two sets of EPS numbers: basic and diluted. The basic figure is the total earnings per share based on the number of shares outstanding at the time. The diluted earnings per share figure reveals how much profit per-share a business would have made if all stock options, warrants, convertibles, etc. were invoked and the additional shares increased the total shares outstanding. The percentage of a company that is represented by these possible share dilutions is called "hang".
Although ABC may have 5 shares outstanding today, it may actually have the potential for 15 shares outstanding during the next year. Valuation on a per-share basis should reflect the potential dilution to each share. Although it is unlikely all of the potential shares will be issued [the stock market may fall, meaning a lot of executives won't exercise the stock options, for example], it is important that you value the business assuming all possible dilution that can take place will take place. This practiced conservatism can mean the difference between mediocre and spectacular returns on your investment.
Below is an excerpt from Intel's 2001 income statement.
Intel
Excerpt - 2001 Annual Report
Earnings per share from continuing operations 2001 2000
Basic $0.19 $1.57
Diluted $0.19 $1.51
In 2000, the difference between Intel's basic and diluted EPS amounted to around $0.06. If you consider the company has over 6.5 billion shares outstanding, you realize that dilution is taking more than $390 million in value from current investors and giving it to management and employees.
Clandestine Boarding on Dishonesty
Some companies don't include the possible share dilution from options that are "underwater". This occurs when an employee owns options to buy shares at a certain price, and due to a sudden drop in stock market value, the option is below the exercise price. If [and this is a big if], the stock does not rise over the exercise price, the option will expire worthless. On the other hand, if the stock advances to higher levels, these options will probably be exercised, increasing the number of shares outstanding, and dilution your percentage ownership in the business.
The problem with not including these underwater options in the diluted figures is that options normally have extended life [in some cases around 10 years]. In that time, it is very likely if not certain that some of those options will become valuable once the company's stock price rises.
Here's an example from Abercrombie & Fitch's 10K:
Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options' exercise prices were greater than the average market price of the underlying shares.
As you analyze companies, you must keep your eye out for such border-line deceptive practices as they are widespread and common occurrence.
Share Repurchase Programs
Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Below is a reprint of an article I published on June 4, 2001.
Stock Buybacks - The Golden Egg of Shareholder Value
"Overall growth is not nearly as important as growth per share..."
All investors have no doubt heard of corporations authorizing share buyback programs. Even if you don't know what they are or how they work, you at least understand that they are a good thing [in most situations]. Here are three important truths about these programs - and most importantly, how they make your portfolio grow.
Principle 1: Overall Growth is not nearly as important as Growth per Share
Too often, you'll hear leading financial publications and broadcast talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow. Growth per share is.
A simplified example may help. Let's look at a fictional company:
Eggshell Candies, Inc.
$50 per share
100,000 shares outstanding
-------------------------------------------
Market Capitalization: $5,000,000
This year, the company made a profit of $1 million dollars.
==================================
In this example, each share equals .001% of ownership in the company. [100% divided by 100,000 shares.]
Management is upset by the company's performance because it sold the exact same amount of candy this year as it did last year. That means the growth rate is 0%! The executives want to do something to make the shareholders money because of the disappointing performance this year, so one of them suggests a stock buyback program. The others immediately agree; the company will use the $1 million profit it made this year to buy stock in itself.
The very next day, the CEO goes and takes the $1 million dollars out of the bank and buys 20,000 shares of stock in his company. [Remember it is trading at $50 a share according to the information above.] Immediately, he takes them to the Board of Directors, and they vote to destroy those shares so that they no longer exist. This means that now there are only 80,000 shares of Eggshell Candies in existence [instead of the original 100,000].
What does that mean to you? Well, each share you own no longer represents .001% of the company... it represents .00125% of the company... that's a 25% increase in value per share! The next day you wake up and find out that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the company didn't grow this year, you still made a twenty five percent increase on your investment! This leads to the second principle.
Principle 2: When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater percentage of equity in the company.
If a shareholder-friendly management such as this one is kept in place, it is possible that someday there may only be 5 shares of the company, each worth one million dollars. When putting together your portfolio, you should seek out businesses that engage in these sort of pro-shareholder practices and hold on to them as long as the fundamentals remain sound. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 in recent months. That is long term value!
Principle 3: Stock Buybacks are not good if the company pays too much for its own stock!
Even though buybacks can be huge sources of long-term profit for investors, they are actually harmful if a company pays more for its stock than it is worth. In an overpriced market, it would be foolish for management to purchase equity at all [even in itself].
Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market swung the other way and is trading below its true value, shares of the company can be bought back up at a discount - giving shareholders maximum benefit.
Remember, "even the best investment in the world isn't a good investment if you pay too much for it".
Return on Equity - ROE
One of the most important profitability metrics is return on equity [or ROE for short]. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It's what the shareholders "own". Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.
A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder's equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher you can get the "return" on your equity, in this case 5%, the better.
The formula for Return on Equity is:
Net Profit
----------(divided by)----------
Average Shareholder Equity for Period
Martha Stewart Living Omnimedia, Inc.
Excerpt - 2001 Consolidated Balance Sheet
(in thousands except per share data) 2001 2000
Total Shareholders' Equity 222,192 196,116
Total liabilities and shareholders' equity 311,621 287,414
Martha Stewart Living Omnimedia, Inc.
Excerpt - 2001 Consolidated Balance Sheet
(in thousands except per share data) 2001 2000
Total Shareholders' Equity 222,192 196,116
Total liabilities and shareholders' equity 311,621 287,414
Now that we have the income statement and balance sheet in front of us, our only job is to plug a the numbers into our equation. The earnings for 2001 were $21,906,000 [because the amounts are in thousands, take the figure shown, in this case $21,906, and multiply by 1,000. Almost all publicly traded companies short-hand their financial statements in thousands or millions to save space]. The average shareholder equity for the period is $209,154,000 [$222,192,000 + 196,116,000 divided by 2].
Let's plug the numbers into the formula.
$21,906,000 earnings
-------------(divided by) -------------
$209,154,000 average shareholder equity for period
The answer is 0.1047, or 10.47%. This 10.47% is the return that management is earning on shareholder equity. Is this good? For most of the twentieth century, the S&P 500 [a measure of the biggest and best public companies in America] averaged ROE's of 10 to 15%. In the 1990's, the average return on equity was in excess of 20%. Obviously, these twenty-plus percent figures probably won't endure forever. In the past two years alone, small and large corporations alike have issued repeated earnings revisions, warning investors they will not meet analysts' quarterly and / or annual estimates.
Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO's in their annual reports about, "achieving record earnings". Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report "record earnings" because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management's fiscal adeptness than the annual earnings per share.
The return on equity calculation can be as detailed as you desire. Most financial sites and resources calculate return on common equity by taking the income available to the common stock holders for the trailing [most recent] twelve months and dividing it by the average shareholder equity for the most recent five quarters. Some analysts will actually "annualize" the recent quarter by simply taking the current income and multiplying it by four. The theory is that this will equal the annual income of the business. In many cases, this can lead to disastrous and grossly incorrect results. Take a retail store such as Lord & Taylor or American Eagle, for example. In some cases, fifty-percent or more of the store's income and revenue is generated in the fourth quarter during the traditional Christmas shopping period. An investor should be exceedingly cautious not to annualize the earnings for seasonal businesses.
Calculating Asset Turnover
The asset turnover ratio calculates the total sales [revenue] for every dollar of assets a company owns. To calculate asset turnover, take the total revenue and divide it by the average assets for the period studied. [Note: you should know how to do this. In lesson 3 we took the average inventory and receivables for certain equations. The process is the same; take the beginning assets and average them with the ending assets. If XYZ had $1 in assets in 2000 and $10 in assets in 2001, the average asset value for the period is $5 because $1+$10 divided by 2 = $5]. A quick exercise would benefit your understanding.
Asset Turnover:
Total Revenue
---------(divided by) ---------
Average assets for period
Alcoa
2001 Income Statement Excerpt
Period Ending: 31-Dec-01 31-Dec-00 31-Dec-99
Total Revenue $22,859,000,000 $23,090,000,000 $16,447,000,000
Cost Of Revenue $17,857,000,000 $17,342,000,000 $12,536,000,000
Gross Profit $5,002,000,000 $5,748,000,000 $3,911,000,000
Alcoa
2001 Balance Sheet Excerpt
2001 2000 1999
Long Term Assets
Long Term Investments $1,428,000,000 $1,072,000,000 $673,000,000
Property, Plant and Equipment $11,982,000,000 $14,323,000,000 $9,133,000,000
Goodwill $9,133,000,000 $6,003,000,000 $1,328,000,000
Intangible Assets $674,000,000 $821,000,000 $117,000,000
Accumulated Amortization N/A N/A N/A
Other Assets N/A N/A N/A
Deferred Long Term Asset Charges $1,746,000,000 $1,894,000,000 $1,015,000,000
Total Assets $28,355,000,000 $31,691,000,000 $17,066,000,000
In 2001 and 2000, Alcoa [Aluminum Company of America] had $28,355,000,000 and $31,691,000,000 in assets respectively, meaning there were average assets of $30,023,000,000 [$28.355 billion + $31.691 billion divided by 2 = $30.023 billion]. In 2001, the company generated revenue of $22,859,000,000. When applied to the asset turn formula, we find that Alcoa had a turn rate of .76138. That tells you that for every $1 in assets Alcoa owned during 2001, it sold $.76 worth of goods and services.
$22,859,000,000 revenue
---------(divided by) ---------
$30,023,000,000 average assets for period
There are several general rules that should be kept in mind when calculating asset turnover. First, asset turnover is meant to measure a company's efficiency in using its assets. The higher the number, the better [although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses.] The higher a company's asset turnover, the lower its profit margin tends to be [and visa versa].
Return on Assets
Where asset turnover tells an investor the total sales for each $1 of assets, return on assets [or ROA for short] tells an investor how much profit a company generated for each $1 in assets. The return on assets figure is also a sure-fire way to gauge the asset intensity of a business. Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light (in the case of a software companies, once a program has been developed, employees simply copy it to a five-cent disk, throw an instruction manual in the box, and mail it out to stores).
Return on assets measures a company's earnings in relation to all of the resources it had at its disposal [the shareholders' capital plus short and long-term borrowed funds]. Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, it the return on assets and return on equity figures will be the same.
There are two acceptable ways to calculate return on assets.
Option 1:
Net Profit Margin x Asset Turnover
Option 2:
Net income
-----------(divided by) -----------
Average Assets for the Period
The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].
Johnson Controls
2001 Income Statement Excerpt
Period Ending: 30-Sep-01 30-Sep-00 30-Sep-99
Total Revenue $18,427,200,000 $17,154,600,000 $16,139,400,000
Cost Of Revenue $478,300,000 $472,400,000 $419,600,000
Preferred Stock and Other Adjustments ($8,800,000) ($9,800,000) ($13,000,000)
Net Income Applicable to Common Shares $469,500,000 $462,600,000 $406,600,000
Johnson Controls
2001 Balance Sheet Excerpt
2001 2000 1999
Long Term Assets
Long Term Investments $300,500,000 $254,700,000 $254,700,000
Property, Plant and Equipment $2,379,800,000 $2,305,000,000 $1,996,000,000
Goodwill $2,247,300,000 $2,133,300,000 $2,096,900,000
Intangible Assets N/A N/A N/A
Accumulated Amortization N/A N/A N/A
Other Assets $439,900,000 $457,800,000 $457,700,000
Deferred Long Term Asset Charges N/A N/A N/A
Total Assets $9,911,500,000 $9,428,000,000 $8,614,200,000
Total Stockholder Equity $2,985,400,000 $2,576,100,000 $2,270,000,000
Net Tangible Assets $738,100,000 $442,800,000 $173,100,000
The first option requires that we calculate net profit margin and asset turnover. In most of your analyses, you will have already calculated these figures by the time you get around to return on assets. For illustrative purposes, we'll go through the entire process using Johnson Controls as our sample business.
Our first step is to calculate the net profit margin. We divide $469,500,000 [the net income] by the total revenue of $18,427,200,000. We come up with 0.025 (or 2.5%).
We now need to calculate asset turnover. We average the $9,911,500,000 total assets from 2001 and $9,428,000,000 total assets from 2000 together and come up with $9,669,750,000 average assets for the one-year period we are studying. Divide the total revenue of $18,427,200,000 by the average assets of $9,660,750,000. The answer, 1.90, is the total number of asset turns. We now have both of the components of the equation to calculate return on assets:
.025 [net profit margin] x 1.90[asset turn] = 0.0475, or 4.75% return on assets
The second option for calculating ROA is much shorter. Simply take the net income of $469,500,000 divided by the average assets for the period of $9,660,750,000. You should come out with 0.04859, or 4.85%. [Note: You may wonder why the ROA is different depending on which of the two equations you used. The first, longer option came out to 4.75%, while the second was 4.85%. The difference is due to the imprecision of our calculation; we truncated the decimal places. For example, we came up with asset turns of 1.90 when in reality, the asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as possible.
Is a 4.75% ROA good for Johnson Controls? A little research on MSN Money Central shows that the average ROA for Johnson's industry is 1.5%. It appears Johnson's management is doing a much better job than the competitors. This should be welcome news to investors.
Projecting Future Earnings
We will save most of the discussion on future earnings for our later lesson focusing exclusively on valuing a business. As a caveat, let's cover some of the basic principles:
1. The greatest indicator of the future is the past. If a company has grown at 4% for the past ten years, it is very unlikely it will start growing 6-7% in the future [short of some major catalysts]. You must remember this, and guard against optimism. Your financial projections should be slightly pessimistic at worst, outright depressing at best. Being masochistic in finance can be very profitable. It's always the Pollyanna's that get creamed.
2. Companies involved in cyclical industries such as steel, construction, and auto manufacturers are notorious for posting $5 EPS one year and -$2.50 the next. An investor must be careful not to base projections off the current year alone. He / she would be best served by averaging the earnings over the past tens years, and basing coming up with a valuation based on that figure. For more information, read Valuing Cyclical Stocks: Assigning Intrinsic Value to Businesses with Unsteady Earnings.
Formulas, Calculations and Ratios for the Income Statement
You've learned how to analyze an income statement! In segment two, we are going to look at the income statements for three companies in the S&P 500. Below is a list of the equations we have covered in this lesson. You should memorize them as soon as possible.
Gross Margin: gross profit ÷ revenue
R&D to Sales: R&D expense ÷ revenue
Operating Margin: operating income ÷ revenue [also known as operating profit margin]
Interest coverage ratio: EBIT ÷ interest expense
Net Profit Margin: net income [after taxes] ÷ revenue
Return on Equity (ROE): net profit ÷ average shareholder equity for the period
Asset Turnover: revenue ÷ average assets for period
Return on Assets: Net profit margin * asset turnover or net income ÷ total average assets for the period
1Working Capital per Dollar of Sales: Working Capital ÷ Total Sales
1Receivable Turnover: Net Credit Sales ÷ Average Net Receivables for the Period
1Inventory Turnover: Cost of Goods Sold ÷ Average Inventory for the Period
1These calculations were discussed in Investing Lesson 3: Analyzing a Balance Sheet. They require both the balance sheet and the income statement to calculate.
Putting it all Together
At this point, you should have the ability to understand the most common entries on the income statement, calculate and compare gross, operating, and profit margins, examine depreciation policies and put competitors in the same industry on a comparable basis, calculate ROE, ROA, and asset turnover, have a respectable understanding of how businesses account for minority-owned stakes in other companies, explain the difference between basic and diluted earnings-per-share, appreciate share repurchase programs when stock prices are falling, despise share dilution, be able to explain what "underwater" options are, and discuss why EBITDA is a worthless metric. Congratulations! I hope you feel it was time well spent. Although there is always more to learn, you are further ahead than a majority of people who own stocks, mutual funds, or bonds.
In the future, it may help to think of the income statement as following this general outline:
Revenue - Cost of Revenue = Gross Profit
Gross Profit - All Operating Expenses = Operating Profit
Operating Profit - Interest Expense, Income Taxes, and Depreciation = Net Income from
Continuing Operations
Net Income from Continuing Operations - Nonrecurring events [extraordinary items, discontinued
operations, etc] = net income
Net income - preferred stock and other adjustments = net income applicable to common shares
Abercrombie and Fitch - 2001 Annual Income Statement
Now that you have come this far, we are going to analyze three income statements. First on our list is Abercrombie and Fitch, a specialty clothing retailer that has made a name for itself by selling the 'college experience'. As of February 2, 2002, the company operated a total of 491 stores [309 Abercrombie & Fitch stores, 148 abercrombie stores [tailored to a younger audience], and 34 Hollister Co. stores.] Notice that I've included a copy of the balance sheet so we can calculate return on equity, return on assets, etc. All financials are taken from the company's 2001 annual report, pages 19 and 20.
Abercrombie & Fitch
Consolidated Statements of Income
(Thousands except per share amounts)
Fiscal year ended 2001 2000 1999
Net Sales $1,364,853 $1,237,604 $1,030,858
Cost of Goods Sold, Occupancy and Buying Costs 806,816 728,229 580,475
Gross Income 558,034 509,375 450,383
General, Administrative and Store Operating Expense 286,576 255,723 209,319
Operating Income 271,458 253,652 242,064
Interest Income, Net -5064 -7,801 -7,270
Income Before Income Taxes 276,522 261,453 249,334
Provision for Income Taxes 107,850 103,320 99,730
Net Income $168,672 $158,133 $149,604
Net Income Per Share:
Basic $1.70 $1.58 $1.45
Diluted $1.65 $1.55 $1.39
The accompanying Notes are an integral part of these Consolidated Financial Statements
Abercrombie & Fitch
Consolidated Balance Sheets
(Thousands)
2-Feb-02 3-Feb-01
Assets
Current Assets
Cash and Equivalents $167,664 $137,581
Marketable Securities 71,220 -
Receivables 20,456 15,829
Inventories 108,876 120,997
Store Supplies 21,524 17,817
Other 15,455 11,338
Total Current Assets 405,195 303,562
Property and Equipment, Net 365,112 278,785
Deferred Income Taxes - 6,849
Other Assets 239 381
Total Assets $770,546 $589,577
Liabilities and Shareholders' Equity
Current Liabilities
Accounts Payable $31,897 $33,942
Accrued Expenses 109,586 101,302
Income Taxes Payable 22,096 21,379
Total Current Liabilities 163,579 156,623
Deferred Income Taxes 1,165 -
Other Long-Term Liabilities 10,368 10,254
Shareholder's Equity
Common Stock - $.01 par value 1,033 1,033
Paid-In Capital 141,394 136,490
Retained Earnings 519,540 350,868
661,967 488,391
Less: Treasury Stock, at Average Cost -66,533 -65,691
Total Shareholders' Equity 595,434 422,700
Total Liabilities and Shareholders' Equity 770,546 589,577
The accompanying Notes are an integral part of these Consolidated Financial Statements
Gross Margin
The first thing we do is calculate the company's gross margin. Taking the gross profit of $558,034 and dividing it by $1,364,853, we come up with .40996, or almost 41%. Applying the same calculation to previous years, we find that in 2002, company's gross margin was 41.2%, compared with 43.7% in 1999. As a potential owner of the business, you want to find out why the gross margin is falling, and if the trend is expected to continue. If the industry is hit hard by economic conditions, calculate the gross margins over the past three years for Abercrombie's competitors [such as Pacific Sunwear, Gap, or American Eagle] to see if they are experiencing the same problem.
Operating Margin:
We calculate the operating margin as 19.9% during 2001, 20.5% in 2000, and 23.5% in 1999.
Interest Coverage Ratio:
You will notice that the interest income is recorded as net. If you think back to the lesson, you should remember that this means the total interest expense and interest income were added together to offset one another and the resulting figure recorded. In Abercrombie's case, the company recorded -5,064 in interest.
Using this information to calculate the interest coverage ratio, we take the earnings before interest and taxes [EBIT], of $271,458, and divide it by the total interest expense of $5,064. The answer is 53.60. What does this mean? The company can afford to make its interest payments 53+ times. Obviously, it is going to have no problem making its relatively miniscule payments.
Net Profit Margin:
In 2001, Abercrombie had a profit margin of 12.4%. In 2000, the profit margin was 12.8%, while in 1999, it stood at 14.5%. Once again, this doesn't mean much unless you compare it to the profit margins of competitors. Even then, it may be inaccurate because of pricing strategy [for instance, Neiman Marcus may have a slightly higher profit margin than Wal-Mart, but that is because of the two retailers have different pricing strategies and business models.]
Return on Equity - ROE
Here's where we get to the juice. To quickly calculate Abercrombie's return on equity, take the average shareholders' equity [$595,434+422,700 ÷ 2] of $509,067 and divide it into the net profit of $168,672. The answer, .3313, or 33.13%, is the return that management is earning on the retained profits. Obviously, your pocketbook will be much faster enriched if you allow the company to retain all of the profits instead of paying them out as dividends [can you reinvest the earnings at 33%? Probably not!]
If both Abercrombie and a competitor were selling for ridiculously cheap [say 3 times earnings], you would want to go with the business that was generating the highest return on shareholder equity. Considering the average corporation earns between 10 and 15% on its equity, Abercrombie's high ROE should make your mouth water.
Asset Turnover
Taking Abercrombie's average assets of $680,061.5 [$770,546+$589,577 ÷ 2], and dividing it into the total revenue of $1,364,853, we find the company has an asset turn of 2.0. There are several general rules that should be kept in mind when calculating asset turnover. First, asset turn is meant to measure a company's efficiency in using its assets. The higher the number, the better [although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses.] The higher a company's asset turnover, the lower its profit margin tends to be [and visa versa].
Return on Assets
Multiplying the 12.4% net profit margin by the 2.0 asset turn, we get .248, or 24.8% return on assets. Using the second formula, we divide the net income of $168,672 by the $680,061.5 average assets, which we discover is .248 or 24.8%.
Share dilution
As a conservative investor, you should base your valuation on the diluted earnings per share. Unfortunately, if you remember back to our discussion on share dilution, you haven't forgotten the clandestine tactics Abercrombie took by not including all possible stock option dilution in the diluted EPS figure:
From Abercrombie & Fitch's 10K:
Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options' exercise prices were greater than the average market price of the underlying shares.
If you believe that Abercrombie is undervalued at the current market price and therefore expect the stock to rise, some of these underwater options may become exercisable, reducing the EPS even further. You would be wise to make a provision for these in your valuation [for instance, if you take the net income of $168,672,000 and divide it by the diluted EPS of $1.65, you can see that management estimates the possibility of a total of 102,225,454+ shares outstanding. You may want to add the 5,630,000 underwater shares to this figure, making the fully diluted outstanding shares stand at around 107,855,454. Now, taking the net income of $168,672,000 and dividing it by the true fully diluted figure, you would get diluted EPS of $1.56 instead of $1.65.]
Although there is a possibility of these shares not being exercised, practiced conservatism can make a big difference to your pocketbook over time.
Final Thoughts on the Company
A quick look at the income statement shows that sales, gross profit, operating profit, and the basic and diluted EPS have increased steadily for the past few years, even though the gross, operating, and profit margins have fallen slightly. These factors, combined with the high return on shareholders' equity should leave an investor fully satisfied with the business. Management has clearly created shareholder value by increasing the amount of equity on the balance sheet, and reinvesting profits at a high rate of return. If the company's shares were to ever trade low enough, an enterprising investor should have no problem holding Abercrombie in their portfolio if the current conditions persists.
Brown Safety
Brown Safety* [a fictional company], is the manufacturer of safety products such as chemical goggles, fire extinguishers, safety ropes, and scaffolding for construction jobs. In 2001, the company reported record EPS of $2.79, up from just $0.03 the year before.
Brown Safety
Consolidated Statements of Income
(Thousands except per share amounts)
Fiscal year ended 2001 2000 1999
Net Sales $5,000 $10,000 $20,000
Cost of Goods Sold, Occupancy and Buying Costs 2,500 5,000 10,000
Gross Income 2,500 5,000 10,000
General, Administrative and Store Operating Expense 1,000 1,000 1,000
Operating Income 1,500 4,000 9,000
Interest Income, Net 0 0 0
Income from Continuing Operations Before Income Taxes 1,500 4,000 9,000
Investment Income $350,000 0 0
Provision for Income Taxes 70,510 600 1,350
Net Income $279,490 3,400 7,650
Net Income Per Share:
Basic $2.79 $0.03 $0.08
Diluted $2.79 $0.03 $0.08
The accompanying Notes are an integral part of these Consolidated Financial Statements
100,000 shares outstanding
Those of you who looked closely at Brown's income statement may have caught on to my trick. Excellent job. If you didn't, let me explain.
Deteriorating Core Operations
In 1999, Brown had a 38.25% profit margin. In 2000, Brown had a 34.0% profit margin. In 2002, Brown had a 25.5% profit margin. Don't believe me? Look close at the income statement. You will see that each year, the total profit and revenues have been cut in half, while SG&A expenses remained at a steady $1,000 [which caused the decreasing profit margin]. In the most recent year, Brown only made $1,500 pre-tax from its continuing operations. Assuming a 15% tax rate, the net profit would have worked out to $1,275 had it not been for investment income.
In the most recent year, Brown realized $350,000 in investment income. Without this one-time boost to earnings, the company would have reported EPS of just over $0.01. To drive home what these means, assume Brown is trading at $5 per share [any number will do, this is solely for illustrative purposes]. A well-meaning but less-than-astute investor may scan the stock tables one morning and see that Brown is trading at a a p/e ratio of 1.8 [$5 per share ÷ $2.79 EPS]. He gets excited, throws up his hands and calls his broker to buy as many shares as possible. At this rate, he'd be earning 55.8% on his investment!
Unfortunately, in a year or so, the investor will have a very unpleasant surprise. If the current decline in the core business persists, the company will report earnings of $0.005 [that's half a penny!] per share. This makes the p/e ratio 1,000! Instead of a 55.8% return on his investment in 2002, the shareholder will earn a pathetic .001%. He is going to lose a major portion, if not all, of his investment unless the business has a large portfolio of stocks and bonds that it can distribute to shareholders or continue selling for cash [as was the case of the Northern Pipe Line, an oil transportation company managed by the Rockefellers. The stock was trading at $65 per share when Benjamin Graham studied the balance sheet and realized the company had bond holdings worth $95 for each share. The value investor tried to convince management to sell the portfolio off, but they refused. Shortly thereafter, he waged a proxy war and secured a spot on the Board of Directors. The company sold its bonds off and paid a dividend in the amount of $70 per share.]
The Moral
Why the over-simplified example? There will come a day when you are analyzing a business, and on the surface, it will seem that earnings are increasing and management is doing a splendid job. Upon closer examination, you may find that the core business is actually losing money, and all of the reported profits come from one-time events such as the sale of a business unit, real estate, intellectual property, marketable securities, or any other number of assets. Unless you are buying a company because you believe its liquidation value is higher than its current market price, you could be in for a rude awakening when management suddenly doesn't have anything left to sell or the losses in the core business have spiraled out of control.
About, Inc
[AM-UG3EK]
Introduction
How many times have you flipped to the back of a company's annual report and found yourself blankly staring at the pages of numbers and tables? You know that these should be important to your investing decision, but you're not quite sure what they mean or where to begin.
In Lesson 3, we're going to take our first major step towards changing that. Smart investors have always known that financial statements are the keys to every company. They can warn of potential problems, and when used correctly, help determine what a business is really "worth". An investor who understands financial statements will never have to ask "is this company a good investment?".
For every business, there are three important financial statements you must look at; the Balance Sheet, the Income Statement, and the Cash Flow Statement. The balance sheet tells investors how much money the company has, how much it owes, and what is left for the stockholders. The cash flow statement is like a business' checking account; it shows you where the money is spent. The income statement is a record of the company's profitability. It tells you how much money a corporation made (or lost).
In this lesson, we are going to learn to analyze a balance sheet. There are two segments: in the first, we will go through a typical balance sheet and explain what each of the items means. In the second, we will actually look at the balance sheets of several American corporations and perform basic financial calculations on them.
Grab a cup of coffee, a nearby calculator and let's begin!
How to Get a Copy of a Company's Balance Sheet
Since you can't do your analysis without a balance sheet, you're going to have to get your hands on one. How do you get a company's financial statements? Generally, you should look in one of three places.
1.) The Annual Report: The annual report is a document released by companies at the end of their fiscal year which includes almost everything an investor needs to know about the business. It generally contains pictures of facilities, branch offices, employees, and products [all of which are completely unimportant to making your investing decision.] They are normally followed by a letter from the CEO and other senior management which discusses the past as well as upcoming year. Tucked away in the back of most annual reports is a collection of financial documents. Most of the time you can go onto a company's website and find the Investor Relations link. From there, you should be able to either download the annual report in PDF form or find information on how to contact shareholder services and request a copy in the mail.
2.) The 10K: This is a document filed with the SEC which contains a detailed explanation of a business. It is reported annually and contains the same financial statements the annual report does, in a more detailed form. The benefit of the 10K is that it allows you to find out additional information such as the amount of stock options awarded to executives at the company, as well as a more in-depth discussion of the nature of the business and marketplace. Sometimes you will find that a company has no financial statements in the 10K, but instead has written, "incorporated herein by reference" This means that the financial statements can be found elsewhere [such as in the annual report or another publication]. Even if this is the case, it is still worth it to get a copy. You can find this by contacting the company, visiting their website, or going to FreeEdgar (freeedgar.com) or SEC.gov.
3.) The 10q: The is similar to the 10k, but is filed quarterly [four times a year - normally the end of January, June, September, and December]. If the company is planning on changing its dividend policy, or something equally as important, they may bury it in the 10q. These documents are critical and can be obtained in the same way as the annual report and 10k.
You will want to get a copy of all three documents for the past year or two from the company you are interested in investing in. Most of them can be found at http://finance.yahoo.com - type in the ticker symbol of the company you want to research and then click the "financials" link. This will bring up a copy of the latest quarterly financial statements. (For all good purposes, I would recommend you first analyze the annual balance sheet, which can be found by clicking "annual data" in the upper right hand corner.) Another excellent source of financial statements is The Street. As always, it is best to get the information directly from the company.
What is a Balance Sheet?
Pretend that you are going to apply for a loan to put a swimming pool into your backyard. You go to the bank asking to borrow money, and the banker insists that you give him a list of your current finances. After going home and looking over your statements, you pull out a blank sheet of paper and write down everything you have that is of value [your checking and savings account, mutual funds, house, and cars]. Then, at the bottom of the sheet your write down all of your debt [the mortgage, car payments, and your student loan]. You subtract everything you owe by all the stuff you have and come up with your net worth.
Congratulations, you just created a balance sheet.
Just as the bank asked you to put together a balance sheet to evaluate your credit-worthiness, the government requires companies to put them together several times a year for their shareholders. This allows current and potential investors to get a snapshot of a company's finances. Among other things, the balance sheet will show you the value of the stuff the company owns [right down to the telephones sitting on the desk of their employees], the amount of debt, how much inventory is in the corporate warehouse, and how much money the business has to work with in the short term. It is generally the first report you want to look at when valuing a company.
Before you can analyze a balance sheet, you have to know how it is set-up.
Note: Unlike other financial statements, the balance sheet cannot cover a range of dates. In other words, it may be good "as of December 31, 2002", but can't cover from December 1 - December 31. This is because a balance sheet lists items such as cash on hand and inventory, which change daily.
Assets, Liabilities and Shareholder Equity
Every balance sheet is divided into three main parts - assets, liabilities, and shareholder equity.
- Assets are anything that have value. Your house, car, checking account, and the antique china set your grandma gave you are all assets. Companies figure up the dollar value of everything they own and put it under the asset side of the balance sheet.
- Liabilities are the opposite of assets. They are anything that costs a company money. Liabilities include monthly rent payments, utility bills, the mortgage on the building, corporate credit card debt, and any bonds the company has issued.
- Shareholder equity is the difference between assets and liability; it tells you the "book value", or what is left for the stockholders after all the debt has been paid.
Every balance sheet must "balance". The total value of all assets must be equal to the combined value of the all liabilities and shareholder equity (i.e., if a lemonade stand had $10 in assets and $3 in liabilities, the shareholder equity would be $7. The assets are $10, the liabilities + shareholder equity = $10 [$3 + $7]).
What Does a Balance Sheet Look Like?
Below is an example of what a typical balance sheet looks like.
Coca-Cola Company
Consolidated Balance Sheet - January 31, 2001
Assets
Current Assets
Dec. 31, 2000
Dec. 31, 1999
Cash and Cash Equivalents $1,819,000,000 $1,611,000,000
Short Term Investments $73,000,000 $201,000,000
Receivables $1,757,000,000 $1,798,000,000
Inventories $1,066,000,000 $1,076,000,000
Prepaid expenses and other $1,905,000,000 $1,794,000,000
Total Current Assets $6,620,000,000 $6,480,000,000
Long Term Assets
Long Term Investments $8,129,000,000 $8,916,000,000
Property, Plant and Equipment $4,168,000,000 $4,267,000,000
Goodwill $1,917,000,000 $1,960,000,000
Intangible Assets N/A N/A
Accumulated Depreciation (or Amortization)
N/A N/A
Other Assets N/A N/A
Deferred Long Term Asset Charges N/A N/A
Total Assets $20,834,000,000 $21,623,000,000
Liabilities
Current Liabilities
Accounts Payable $9,300,000,000 $4,483,000,000
Short Term Debt $21,000,000 $5,373,000,000
Other Current Liabilities N/A N/A
Total Current Liabilities $9,321,000,000 $9,856,000,000
Long-Term Liabilities
Long Term Debt $835,000,000 $854,000,000
Other Liabilities $1,004,000,000 $902,000,000
Deferred Long Term Liability Charges $358,000,000 $498,000,000
Minority Interest N/A N/A
Total Liabilities $11,518,000,000 $12,110,000,000
Shareholder's Equity
Misc. Stock Option Warrants N/A N/A
Redeemable Preferred N/A N/A
Preferred Stock N/A N/A
Common Stock $870,000,000 $867,000,000
Retained Earnings $21,265,000,000 $20,773,000,000
Treasury Stock ($13,293,000,000) ($13,160,000,000)
Capital Surplus $3,196,000,000 $2,584,000,000
Other Stockholder Equity ($2,722,000,000) ($1,551,000,000)
Total Stock Holder Equity $9,316,000,000 $9,513,000,000
Net Assets $7,399,000,000 $7,553,000,000
Current Assets
The first thing listed under the asset column on the balance sheet is something called "current assets". This is where companies list all of the stuff that can be converted into cash in a short period of time [usually a year or less]. Because these assets are easily turned into cash, they are sometimes referred to as "liquid". They normally consist of:
Cash and Cash Equivalents
Cash and Cash Equivalents is the amount of money the company has in bank accounts, savings bonds, certificates of deposit, and money market funds. It tells you how much money is available to the business immediately. How much should a company keep on the balance sheet? Generally speaking, the more cash on hand the better. Not only does a decent cash hoard give management the ability to pay dividends and repurchase shares, but it can provide extra wiggle-room when times get bad.
There are some cases where cash on the balance sheet isn't necessarily a good thing. If a company is not able to generate enough profits internally, they may turn to a bank and borrow money. The money sitting on the balance sheet as cash may actually be borrowed money. To find out, you are going to have to look at the amount of debt a company has (we will be discussing this later on in the lesson). The moral: You probably won't be able to tell if a company is weak based on cash alone; the amount of debt is far more important.
Short Term Investments
These are investments that the company plans to sell shortly or can be sold to provide cash. Short term investments aren't as readily available as money in a checking account, but they provide added cushion if some immediate need were to arise. Short Term Investments become important when a company has so much cash sitting around that it has no qualms about tying some of it up in slightly longer-term investment vehicles (such as bonds which have maturities of less than one year). This allows the business to earn a slightly higher interest rate than if they stuck the cash in a corporate savings account.
Perhaps the most legendary cash hoard in the business world right now is Microsoft's - the company has $5.25 billion in cash and $32.973 billion in short term investments.
Receivables
Also sometimes known as "Account Receivables", this is money that is owed to a company by its customers.
Here's how it works: Let's say Wal-Mart wants to order a new DVD which is being released by Warner Brothers. Wal-Mart orders 500,000 copies for its stores. Warner Brothers receives the order, and within a week, ships the DVDs to one of Wal-Mart's warehouses. Included in the shipment is a bill (let's say WB charged Wal-Mart $5 per DVD for half a million copies - that's $2.5 million). Warner Brothers has already sent the movies to Wal-Mart, even though Wal-Mart hasn't paid a penny. In essence, Wal-Mart is buying on credit and promising to pay WB's the $2.5 million.
The $2.5 million would go on Warner Brother's balance sheet as receivables.
Generally a company that sells a product on credit sets a term. The term is the number of days customers must pay their bill before they are charged a late fee or turned over to a collection agency (most terms are, 30, 60 or 90 days). If Warner Brothers sold the DVDs to Wal-Mart on a 30 day term, Wal-Mart must pay its bill during that time.
While accounts receivable are good, they can bring serious problems to a business if they aren't handled properly. What if Wal-Mart went bankrupt or simply didn't pay Warner Brothers? WB would then be forced to write down its receivables on the balance sheet by $2.5 million. This is what is called a delinquent account. Normally, companies build up something called a reserve to prepare for situations such as this. Reserves are set amounts of money that are taken out of the profits each year and put into an account specifically designed to act as a buffer against possible loses the company may incur. (Reserves are touched on in Part 29). When customers don't pay their bills, companies can take money out of the reserve they had built up to pay back suppliers.
Receivable Turns
Common sense tells you the faster a company collects its receivables, the better. The sooner customers pay their bills, the sooner a company can put the cash in the bank, pay down debt, or start making new products. There is also a smaller chance of losing money to delinquent accounts. Fortunately, there is a way to calculate the number of days it takes for a business to collect its receivables. The formula looks like this:
Credit Sales (found on the income statement - not the balance sheet)
-------------------------(divided by)---------------------------
Average Receivables
Let's look at an example.
H.F. Beverages Balance Sheet (Excerpt)
2000 1999
Receivables $1,183,363 $1,178,423
Income Statement (Excerpt)
Credit Sales $15,608,300
H.F. Beverages* is a major manufacturer of soft drinks and juice beverages. It sells to supermarkets and convenience stores across the country on a 30 day term. To see if customers are paying on time, we need to look for the income statement. It is normally found within a page or two of the balance sheet in the annual report or 10K. With the income statement in front of you, look for an item called "Credit Sales" (if you can't find it, there is an item called "Total Sales" which is acceptable but not as accurate).
In 2000, H.F. Beverages reported credit sales of $15,608,300. If we look at the excerpt from its balance sheet (above), we will see that in 2000, it had $1,183,363 in receivables and in 1999, $1,178,423. We need to find out the average amount of receivables H.F. had in 2000, so we would take $1,1873,363 + $1,178,423 and divide it by 2. The answer is $1,180,893.
Plug the two numbers into the formula.
Credit Sales = $15,608,300
------------(divided by)--------------
Average Receivables = $1,180,893
The answer, called "Receivable Turns" by financial analysts, is 13.2173. This means that H.F. Beverages collects its accounts receivable 13.2173 times per year. Once you calculate this number, finding out the number of days it takes for customers to pay their bills is simple. Since there are 365 days in a year and the company gets 13.2173 turns per year, take 365 ÷ 13.2173. The answer is the number of days it takes the average customer to pay (in H.F.'s case, we come up with 27.61).
This means the company is doing a good job managing its accounts receivable because customers aren't exceeding the 30 day policy. Had the answer been greater than 30, you would have been wise to try to find out why there were so many late payments, which could be a sign of trouble. (Keep in mind you will need to read through the company's reports to find out what its collection deadline is. Not all companies require their customers to pay within 30 days).
*A Fictional Company for illustration only
Inventories
When looking at a company's current assets, you need to pay special attention to inventory. Inventory consists of merchandise a business owns but has not sold. It is classified as a current assets because investors assume that inventory can be sold in the near future, turning it into cash.
To come up with a balance sheet amount, companies must estimate the value of their inventory. For instance, if Nintendo had 5,000 units of its new video game system, the Game Cube, sitting in a warehouse in Japan, and expected to sell them to retailers for $300 each, they would be able to put $1,500,000 on their balance sheet as the value of their current inventory (5000 units x $300 each = $1.5 million).
This presents an interesting problem. When inventory piles up, it faces two major risks. The first is the risk of obsolesce. In another year, few stores will probably be willing to buy the Game Cube video game system for $300 simply because a newer, faster, and better system may have come along. Although the inventory is carried on the balance sheet at $1.5 million, it may actually lose value as time passes. When you hear that a company has taken an inventory write-off charge, it means that management essentially decided the products that were sitting in storage or on the store shelves weren't worth the values they were stated at on the balance sheet. To correct this, the company will reduce the carrying value of its inventory.
If a year passes and Nintendo still has 3000 of the 5000 units in storage, the executives may decide to lower their prices hoping to sell the remaining inventory. If they lower the Game Cube's price to $200 each, they would have 3000 units at $200. Before, those 3000 units were stated at a value of $900,000 on the balance sheet. Now, because they are selling for less, the same units are only worth $600,000. The risk of obsolesce is especially present in technology companies or manufacturers of heavy machinery.
Another inventory risk is spoilage. Spoilage occurs when a product actually goes bad. This is a serious concern for companies that make or sell perishable goods. If a grocery store owner overstocks on ice cream, and two months later, half of the ice cream has gone bad because it has not been purchased, the grocer has no choice but to throw it out. The estimated value of the spoiled ice cream must be taken off the grocery store's balance sheet.
The moral of the story: the faster a company sells its inventory, the smaller the risk of value loss.
Inventory Turn
Before you invest, you are going to have to make an informed decision about how much you think the inventory is really worth. A major part of this decision should be based on how fast the inventory is "turned" (or sold). Two competing companies may each have $20 million sitting in inventory, but if one can sell it all every 30 days, and the other takes 41 days, you have less of a risk of inventory loss with the 30 day company.
Finding out how fast a company turns its inventory is simple. Here's the formula:
Current Year's Cost of Goods Sold or Cost of Revenues (found on the income statement - not the balance sheet)
----------------------------------------(Divided By)------------------------------------------
The average inventory for the period
Let's look at a real-world example:
Coca-Cola
Balance Sheet (Excerpt)
2000 1999
Inventories $1,066,000,000 $1,076,000,000
Income Statement (Excerpt)
Cost of Goods Sold $6,204,000,000
The cost of goods sold is $6,204,000,000. The average inventory value between 1999 and 2000 is $1,071,000,000 (average the values from 1999 and 2000). Plug them into the formula.
Current Year's Cost of Goods Sold = $6,204,000,000
----------------------(divided by)----------------------
Average Inventories = $1,071,000,000
The answer is the number of inventory turns - in Coca-Cola's case, 5.7927. What this means is that Coca Cola sells all of its inventory 5.79 times each year. Is this good? To answer this question, you must find out the average turn of Coke's competitors and compare. If you do the research, you find out that the average turnover of a company in Coke's industry is 8.4. Why is Coca-Cola's turn rate lower? Should it affect your investing decision? The only way you can answer these kinds of questions is if you truly understand the business you are analyzing. This is why it is important that you read the entire annual report, 10k and 10q of the companies you have taken an interest in. Although Coke's turn rate is lower, further analysis of the balance sheet will reveal that it is 4 to 5x financially stronger than its industry averages. With such outstanding economics, you probably don't need to worry about inventory losing value.
Let's take the inventory analysis a step further. Once you have the inventory turn rate, calculating the number of days it takes for a business to clear its inventory only takes a few seconds. Since there 365 days in a year and the Coca Cola clears its inventory 5.7927 times per year, take 365 ÷ 5.7927. The answer (63.03) is the number of days it takes for Coke to go through its inventory. This is a great trick to use at cocktail parties; grab a copy of an annual report, scribble the formula down and announce loudly that "Wow! This company takes 63 days to sell through its inventory!" People will instantly think you are an investing genius.
The number of days a company should be able to sell through its inventory varies greatly by industry. Retail stores and grocery chains are going to have a much higher inventory turn rate since they are selling products that generally range between $1 and $50. Companies that manufacture heavy machinery such as airplanes, are going to have a much lower turn over rate since each of their products may sell for millions of dollars. Hardware companies may only turn their inventory 3 or 4 times a year, while a department store may do twice that, turning at 6 or 7. If you want to compare the inventory turnover rate of a company to its competitors, you can go to MSN Money Central.
Inventory in Relation to Current Assets
When analyzing a balance sheet, you also want to look at the percentage of current assets inventory represents. If 70% of a company's current assets are tied up in inventory and the business does not have a relatively low turn rate (less than 30 days), it may be a signal that something is seriously wrong and an inventory write-down is unavoidable.
1It is acceptable to use the total sales instead of the cost of sales. The cost of sales is a more accurate reflection of inventory turn and should be used for the truest results. When comparing the company to others in its industry, make sure you use the same number. You cannot value one company using cost of sales, and another using total sales.
McDonald's vs. Wendy's: An Example
It's easy to see how a higher inventory turn than competitors translates into superior business performance. McDonalds is unquestionably the largest and most successful fast food restaurant in the world. Let's compare it to one of its main competitors, Wendy's.
McDonalds
2000 1999
Inventories $99,300,000 $82,700,000
Cost of Revenue $8,750,100,000
Wendy's
2000 1999
Inventories $40,086,000 $40,271,000
Cost of Revenue $1,610,075,000
Use the inventory turn formula [cost of sales or cost of revenue divided by the average inventory values] to come up with the number of inventory turns for each business. Between 1999 and 2000, McDonalds had an inventory turn rate of 96.1549 [incredible for even a high-turn industry such as fast food]. This means that every 3.79 days, McDonald's goes through its entire inventory. Wendy's, on the other hand, has a turn rate of 40.073 and clears its inventory every 9.10 days.
This difference in efficiency can make a tremendous impact on the bottom line. By tying up as little capital as possible in inventory, McDonalds can use the cash on hand to open more stores, increase its advertising budget, or buy back shares. It eases the strain on cash flow considerably, allowing management much more flexibility in planning for the long term.
The Final Word on Inventory
The bottom line: investors want as little money as possible tied up in inventory. It is fine to have a lot of inventory on the balance sheet if it is being sold at a fast enough rate there is little risk of becoming obsolete or spoiled. Great companies have excellent inventory handling systems so they only order products when they are needed - they never buy too much or too little of something. Businesses that have too much inventory sitting on the shelves or in a warehouse are not being as productive as they could be: had management been wiser, the money could have been kept as cash and used for something more productive.
*Note: These financials were taken from Yahoo! finance on 02/09/02
Prepaid Expenses
In the course of every day operations, businesses will have to pay for goods or services before they actually receive the product. If a jewelry store moved into your neighborhood mall, it would most likely have to sign a rent agreement and pay six to twelve months' rent in advance. If the monthly rent was $1,000 and the business prepaid for an entire year, they would put $12,000 on the balance sheet under Prepaid Expenses ($1,000 monthly rent x 12 months = $12,000). Each month, they would deduct 1/12 from the prepaid expenses until the end of the year, at which point, the amount would be $0.
Sometimes companies decide to prepay taxes, salaries, utility bills, rent, or the interest on their debt. These would all be pooled together and put on the balance sheet under this heading.
By their very nature, Prepaid Expenses are a small part of the balance sheet. They are relatively unimportant in your analysis and shouldn't be given too much attention.
Notes Receivable
Notes Receivable are debts owed to the company which are payable within one year.
Other Current Assets
Other current assets are non-cash assets that are owed to the company within one year.
Non Standard Items
Sometimes companies put items on their balance sheet which aren't standard. If you find yourself analyzing a balance sheet and an oddball term shows up, search for it at investorwords or investopedia. If that still doesn't work, you can call your broker or a local banker, all of whom should be happy to give you an explanation of a term.
I would recommend you get a copy of Barron's "Dictionary of Finance and Investing Terms". They are relatively inexpensive ($10 or $11), and define over 4,000 terms. This can be a huge asset regardless of the financial statement you are looking at. You may also find the "Dictionary of Business Terms" useful as well. It has 7,500 entries covering almost every business definition you could possibly ask for . While neither is required to do balance sheet analysis, they can be a big help.
Current Liabilities
Current liabilities are the debts a company owes which must be paid within one year. They are the opposite of current assets. Current liabilities includes things such as short term loans, accounts payable, dividends and interest payable, bonds payable, consumer deposits, and reserves for Federal taxes.
Let's take a look at some of the most common and important ones.
Accounts Payable
Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it.
Accrued Benefits / Payroll
This is money owed to employees as salary and bonus that the company has not yet paid.
Short Term and Current Long Term Debt
These items are sometimes referred to as notes payable. They are the most important item under current liabilities. Most of the time, they represent a company's bank loans. Borrowing money in itself is not necessarily a sign of financial weakness; an intelligent department store executive may work out short term loans at Christmas so she can stock up on merchandise before the Holiday rush. If demand is high, the store would sell all of its inventory, pay back the short term loans, and pocket the difference. This is known as utilizing leverage. The department store used borrowed money to make a profit.
So how can you ever hope to tell if a company is wisely borrowing money (such as our department store), or recklessly going into debt? Look at the amount of notes payable on the balance sheet (if they aren't classified under 'notes payable', combine the company's short term obligations and long term current debt.) If the amount of cash and cash equivalents is much larger than the notes payable, you shouldn't have any reason to be concerned.
If, on the other hand, the notes payable has a higher value than the cash, short term investments, and accounts receivable combined, you should be seriously concerned. Unless the company operates in a business where inventory can quickly be turned into cash, this is a serious sign of financial weakness.
Other Current Liabilities
Depending on the company, you will see various other current liabilities listed. Sometimes they will be lumped together under the title "other current liabilities." Normally, you can find a detailed listing of what these "other" liabilities are buried somewhere in the annual report or 10k. Often, you can figure out the meaning of the entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly confident the amount listed is what will be paid out to the company's bond holders in the short term.
Consumer Deposits
If you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the current liabilities called "Consumer Deposits". Often, they will be will lumped under other current liabilities. This is the amount that customers have deposited in the bank. Since, theoretically, all of the account holders could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability.
Working Capital
The number one reason most people look at a balance sheet is to find out a company's working capital (or "current") position. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company's position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt.
Working Capital is the easiest of all the balance sheet calculations. Here's the formula:
Current Assets - Current Liabilities = Working Capital
One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time.
Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available.
A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.
Working Capital per Dollar of Sales
To find the approximate amount of working capital a company should have, you should look at "working capital per dollar of sales." In other words, you are going to have to compare the amount of working capital on the balance sheet to the total sales (which is found on the income statement - not the balance sheet). A business that sells a lot of low-cost items, and cycles through its inventory rapidly (a grocery store) may only need 10-15% of working capital per dollar of sales. A manufacturer of heavy machinery and high-priced items with a slower inventory turn may require 20-25% working capital per dollar of sales. A company such as Coca Cola would probably fall somewhere between the two.
Here's the formula for Working Capital per Dollar of Sales
Working Capital
-------------------------(divided by)---------------------------
Total Sales (Found on the Income Statement)
Let's look at an example:
Goodrich, Inc. (Symbol GR)
Goodrich provides systems for aircraft as well as manufacturers heavy-duty engines.
Working Capital: $933,000,000 (current assets - current liabilities)
Total Sales (found on the income statement) = $4,363,800,000
Let's plug the numbers into the formula:
Working Capital = $933,000,000
-------------------------(divided by)---------------------------
Total Sales (Found on the Income Statement) = $4,363,800,000
The answer for Goodrich is .2138, or 21.38%. As a manufacturer of heavy duty machinery, GR falls within the 20-25% working capital per dollar of sales range. This is good.
Negative Working Capital
Some companies can generate cash so quickly they actually have a negative working capital. This is generally true of companies in the restaurant business (McDonalds had a negative working capital of $698.5 million between 1999 and 2000). Amazon.com is another example. This happens because customers pay upfront and so rapidly, the business has no problems raising cash. In these companies, products are delivered and sold to the customer before the company ever pays for them.
Don't understand how a company can have a negative working capital? Think back to our Warner Brothers / Wal-Mart example. When Wal-Mart ordered the 500,000 copies of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the country? By the twentieth day, they may have sold all of the DVDs. In the end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesn't really need to have enough cash on hand to pay all of its accounts payable. As long as the transactions are timed right, they can pay each bill as it comes due, maximizing their efficiency.
The bottom line: A negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis). In any other situation, it is a sign a company may be facing bankruptcy or serious financial trouble.
Buying a Company for Free
If you can buy a company for the value of its working capital, you essentially pay nothing for the business. Going back to our Goodrich example; the company has $933 million in working capital. There are currently 101.9 million shares outstanding, which means each share of Goodrich stock has $9.16 cents worth of working capital. If GR's stock was trading for $9.16, you would basically be purchasing the stock for free (paying $1 for each $1 the company had in its checking account, inventory, etc.). You would pay nothing for the company's fixed assets (such as real estate, computers, & buildings) and earnings.
For the past ten or twenty years, it has been incredibly rare for a company to trade that low. You can still use the basic concept to your advantage; if you can find a business that is trading for working capital plus half the value of the fixed assets, you would be paying $0.50 for every $1.00 of assets.
Current Ratio
The current ratio is another test of a company's financial strength. It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year. You can find the current ratio by dividing the total current assets by the total current liabilities. For example, if a company has $10 million in current assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2).
An acceptable current ratio varies by industry. Generally speaking, the more liquid the current assets, the smaller the current ratio can be without cause for concern. For most industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls below 1 (which means the company has a negative working capital), you will need to take a close look at the business and make sure there are no liquidity issues. Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash. If this is not the case and a company's number is low, you should be seriously concerned.
Inefficiency
If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you may want to be concerned. A number this high means that management has so much cash on hand, they may be doing a poor job of investing it. This is one of the reasons it is important to read the annual report, 10k and 10q of a company. Most of the time, the executives will discuss their plans in these reports. If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to try to find out what is going on.
As I mentioned earlier, Microsoft current has the biggest cash hoard in the business world. It's current ratio is in excess of 4. The company has no long term debt on the balance sheet. What are they planning on doing? No one knows; the software giant may pay a dividend for the first time, pour the money back into research and development, or buy back shares.
Although not ideal, too much cash on hand is the kind of problem a smart investor prays for.
Quick Test Ratio
The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is the most excessive and difficult test of a company's financial strength and liquidity. To calculate the quick ratio, take the current assets and subtract the inventory (current assets minus inventory is often referred to as the "quick assets"). What you are left with are the items that can be converted into cash immediately . Divide the result by the current liabilities. The answer is the Quick Test ratio.
What does this tell you? It is a reflection of the liquidity of a business. The Quick Test ratio does not apply to the handful of companies where inventory is almost immediately convertible into cash (such as McDonalds, Wal-Mart, etc.) Instead, it measures the ability of the average company to come up with cold, hard cash literally in a matter of hours or days. Since inventory is rarely sold that fast in most businesses, it is excluded.
Long Term Assets
Everything we've discussed up until now has been a current asset or liability. Now, we are going to take a look at the long term assets that are found on the balance sheet. These are the things that a business owns but can't be used to fund day-to-day operations.
Long Term Investments
Long Term investments and funds are investments a company intends to hold for more than one year. They can consist of stocks and bonds of other companies, real estate, and cash that has been set aside for a specific purpose or project. In addition to investments a company plans to hold for an extended period of time, Long Term Investments also consist of the stock in a company's affiliates and subsidiaries.
The difference between Short Term and Long Term investments lie in the company's motive for owning them. Short term investments consist of stocks, bonds, etc. a company has bought and will sell shortly. The investments made under long term investments may never be sold. An excellent example would be Berkshire Hathaway's relationship with Coca-Cola. Berkshire owns 200 million shares of the soft-drink giant, and will most likely continue to hold them forever, regardless of the price they are selling for in the open market.
Carrying Values of Stock Investments
As you now know, when a business purchases common stocks as an investment, they will go into either the Short Term or Long Term Investment categories on the balance sheet. These are normally carried on the balance sheet at cost or market value (whichever is less). This means that most of the time, the stocks the company owns are worth far more than they are on the balance sheet (for example, if a business owned 50,000 shares of Sprint and they paid $10 per share, they would have $500,000 on the balance sheet under either short term or long term investments. If Sprint rose to $35 per share, the value of their holdings would be $1,750,000, yet the balance sheet would continue to carry $500,000. Thus, the difference of $1,250,000 would not be included in the book value of the company. (This is a prime example of how financial statements are only the beginning of the valuation process. They have their limitations, but without them, we would have no basis to calculate intrinsic value.)
Property, Plant and Equipment
These are referred to as "fixed assets". In other words, these are the corporation's real estate, buildings, office furniture, telephones, cafeteria trays, brooms, factories, etc. They are the physical assets the company owns but can't quickly convert to cash.
Depending on the type of business, these may or may not make up a large percentage of the total assets. Most of the assets of a railroad or airline will fall into this category (these companies must continue to buy railroad cars and planes to survive - both of which are fixed assets). An advertising agency on the other hand, will have far fewer fixed assets. They require nothing but their employees, some pencils, and a few computers.
You must be careful not to pay too much attention to this number. Since companies are often unable to sell their fixed assets within any reasonable amount of time (who would be willing to buy 3 notebook binders, a factory, the broom in the broom closet, etc. at a moment's notice?) they are carried on the balance sheet at cost regardless of their actual value. It is possible for companies to grossly inflate this number (which is called "watering" the stock), or to write the values down to nothing (some companies have $1 million dollar buildings carried for $1 on the balance sheet).
When analyzing a balance sheet, you will want to look at this number with a raised eyebrow. Don't completely ignore it (that would be foolish), but certainly don't take it too seriously.
Intangible Assets
Companies often own things of value that cannot be touched, felt, or seen. These consist of patents, trademarks, brand names, franchises, and economic goodwill (which is different than the accounting goodwill we've discussed. Economic goodwill consists of the intangible advantages a company has over its competitors such as an excellent reputation, strategic location, business connections, etc.) While every effort should be made for businesses to carry them at costs on the balance sheet, they are normally given completely meaningless values.
To prove the point that the intangible value assigned on the balance sheet can be deceptive, here's an excerpt from Michael F. Price's introduction to Benjamin Graham's "The Interpretation of Financial Statements"...
In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max Heine asked me to look at a small brewery - the F&M Schaefer Brewing Company. I'll never forget looking at the balance sheet and seeing a +/- $40 million net worth and $40 million in 'intangibles'. I said to Max, 'It looks cheap. It's trading for well below its net worth.... A classic value stock!' Max said, 'Look closer.'
I looked in the notes and at the financial statements, but they didn't reveal where the intangibles figure came from. I called Schaefer's treasurer and said, 'I'm looking at your balance sheet. Tell me, what does the $40 million of intangibles related to?' He replied, 'Don't you know our jingle, 'Schaefer is the one beer to have when you're having more than one.'?'
That was my first analysis of an intangible asset which, of course, was way overstated, increased book value, and showed higher earnings than were warranted in 1975. All this to keep Schaefer's stock price higher than it otherwise would have been. We didn't buy it."
When analyzing a balance sheet, you should generally ignore the amount assigned to intangible assets. These intangible assets may be worth a huge amount in real life (Coca-Cola's brand name is priceless), but it is the income statement, not the balance sheet, that gives investors insight into the value of these intangible items.
Goodwill
In the accounting sense, Goodwill can be thought of as a "premium" for buying a business. When one company buys another, the amount they pay is called the purchase price. Accountants take the purchase price and subtract it by a company's book value. The difference is called Goodwill. (There is a review of book value in Part 27.)
When a company buys another company, they can use one of two accounting methods: pooling of interest or purchase. When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created. When the purchase method is used, the acquiring company will put the premium they paid for the other company on their balance sheet under the "Goodwill" category. Accounting rules require the goodwill be amortized over the course of 40 years.
What does that mean? Let's use McDonalds and Wendy's as an example since most people are familiar with them.
McDonalds
Earnings: $1,977,300,000
Shares Outstanding: 1.29 Billion
(You don't need McDonalds other information for this example)
Wendy's
Book Value: $1,082,424,000
Book Value per Share: $10.3482
Shares Outstanding: 104.6 Million
Earnings: $169,648,000
Say McDonalds decided to buy all of Wendy's stock using the purchase method. Wendy's has a book value of $10.3482 per share, yet is trading at $32 per share. If McDonalds were to pay the current market price, they would spend a total of $3,347,200,000 (104.6 million shares x $36 per share). To keep this example simple, we are going to assume the shareholders of Wendy's approved the merger for cash. McDonalds would mail a check to the Wendy's shareholders, paying them $32 for each share they owned.
Since the book value of Wendy's is only $1,082,424,000, and McDonalds paid $3,347,200,000, McDonalds paid a premium of $2,264,776,000. This is going to go onto their balance sheet as Goodwill. It is required to be amortized against earnings for up to 40 years. This means that each year, 1/40 of the goodwill amount must be subtracted from McDonalds' earnings so that by the 40th year, there is no goodwill left on the balance sheet.
Now that McDonalds and Wendy's are one company, their earnings will be combined. Assuming next year's results were identical, the company would earn $2,146,948,000, or $1.66 per share1. Remember that goodwill must be amortized, meaning 1/40 the amount must be deducted from next year's earnings. McDonalds must deduct $56,619,400 from earnings next year as a charge against goodwill2. Now, McDonalds can only report earnings of $2,090,328,600, or $1.62 per share (compared to the $1.66 they would have been able to report before the goodwill charge). Goodwill reduced earnings by 4¢ per share.
If the pooling of interest method had been used, no goodwill would have been created, and McDonalds would have reported EPS (earnings per share) of $1.66. Meaning that depending on how the accounting was handled, the exact same transaction could have two vastly different impacts on earnings per share.
It is no wonder that managements, in order to avoid this reduction in reportable earnings, frequently opt to use the pooling of interest method when they complete a merger. Since no goodwill is created, over-eager managers are able to pay outrageous prices for acquisitions with little or no accountability on the balance sheet. Since it makes no sense to have two different ways for accounting for a merger, the FASB (the folks in charge of coming up with these accounting rules) decided they should eliminate the pooling of interest method and force all transactions to be done via the purchase method. Executives and politicians claimed this will significantly reduce the number of mergers since the new standards would cause reportable earnings to drop as soon as a company had completed an acquisition. As a concession, the FASB will no longer require goodwill to be written off unless the assets became impaired (which means it becomes clear that the goodwill isn't worth what the company paid for it).
Pay careful attention to the mergers a company has made in the past few years. Once you are able to value a business, you will want to look at recent acquisitions to determine if they were too expensive. If you find this to be the case, you will probably want to avoid the stock (why would you want to invest in a company that was throwing your money around?).
Notes:
1.) Since McDonalds purchased Wendy's, the two companies' profits will be combined. $1,977,300,000 + $169,648,000 = $2,146,948,000. To get the earnings per share, you would simply divide it by the number of shares outstanding (1.29 billion). We're assuming McDonalds bought Wendy's for cash. If stock had been used, the number of shares would change, but for simplicity sake, we are going to assume this not to be the case.
2.) Take the premium $2,264,776,000 and divide it by 40 years = this is the charge against earnings each year
3.) Companies purchased before 1970 are not required to be amortized off the balance sheet. They can stay there forever.
Other Assets
Other Assets are non-cash assets which are owed to the company for a period longer than one year.
Deferred Long Term Asset Charges
These are expenses which the company has paid for but not yet subtracted from the assets. They are very similar to Prepaid Expenses (where rent would be counted as an asset until it came due each month, then would be subtracted from the balance sheet). In fact, Prepaid Expenses are type of deferred charge. The difference is, when companies prepay rent or some other expense, they have a legal right to collect the service. Deferred Long Term Asset Charges have no legal rights attached to them.
For example, if a company prepaid rent on a storage building, and then spent $30,000 moving all of their equipment into it, they could set the $30,000 up on the balance sheet as a deferred charge. This way, they wouldn't be forced to take a hit by reducing their earnings $30,000 the same month they paid for the relocation costs. They could then write this amount down over time.
These charges are intangible and should be given very little weight when analyzing a balance sheet.
Long Term Debt
The amount of long term debt on a company's balance sheet is crucial. It refers to money the company owes that it doesn't expect to pay off in the next year. Long term debt consists of things such as mortgages on corporate buildings and / or land, as well as business loans.
A great sign of prosperity is when a balance sheet shows the amount of long term debt has been decreasing for one or more years. When debt shrinks and cash increases, the balance sheet is said to be "improving". When it's the other way around, it is said to be "deteriorating". Companies with too much long term debt will find themselves overwhelmed with interest payments, a risk of having too little working capital, and ultimately, bankruptcy. Thankfully, there is a financial tool that can tell you if a business has borrowed too much money.
Debt to Equity Ratio
The Debt to Equity Ratio measures how much money a company should safely be able to borrow over long periods of time. It does this by comparing the company's total debt (including short term and long term obligations) and dividing it by the amount of owner's equity (which is explained in part 23. For now, you only need to know that the number can be found at the bottom of the balance sheet. You'll actually calculate the debt to equity ratio in segment two when we look at real balance sheets.)
The result you get after dividing debt by equity is the percentage of the company that is indebted (or "leveraged"). The normal level of debt to equity has changed over time, and depends on both economic factors and society's general feeling towards credit. Generally, any company that has a debt to equity ratio of over 40 to 50% should be looked at more carefully to make sure there are no liquidity problems. If you find the company's working capital, and current / quick ratios drastically low, this is is a sign of serious financial weakness.
Profitable Borrowing
If a business can earn a higher rate of return than the interest rate at which it borrows, it becomes profitable for the business to borrow money. (An example: If a corporation earned 15% on its investments and borrowed funds at 8%, it would make 7% on the borrowed money [15% return - 8% cost of money = 7% net profit]. This boosts what analysts call "Return on Equity". We will talk about Return on Equity, or ROE, in a future lesson. It is briefly touched on in the Retained Earnings section of this lesson.)
Other Liabilities
Like the few other "other" parts of the balance sheet, "Other Liabilities" is a catch-all category where companies can consolidate their miscellaneous debt. You can normally find an explanation of what makes up these other liabilities somewhere in the financial reports. Often times, they consist of things such as inter-company borrowings (where one of a company's divisions or subsidiaries borrows from another), accrued expenses, sales tax payable (in the instance of retail stores), etc.
Generally, you should take the time to look at the various other liabilities a company has. Most are self explanatory and are not as important as the other major liabilities already discussed.
Minority Interest
When you look at a balance sheet, you will see an entry called "Minority Interest". This refers to the equity of the minority shareholders in a company's subsidiaries. An example will help clarify.
In 1983, Nebraska Furniture Mart was the most successful home furnishings store in the United States. It's gross annual sales exceeded $88.6 million, and the company had no debt. At the time, Warren Buffett, the CEO of Berkshire Hathaway, was searching for great businesses to acquire. After noticing how successful the furniture business appeared to be, he approach the owner, Rose Blumpkin, and offered to buy the company.
Almost immediately, Rose offered to sell 90% of Nebraska Furniture Mart to Berkshire for $55 million. The next day, Buffett walked into the store and handed her a check. This made NFM a partially-owned subsidiary of Berkshire. (A subsidiary is a company controlled by another company through ownership of at least a majority of the voting stock.) Since subsidiaries are controlled by their parent companies, accounting rules allow for them to be carried on the parent company's balance sheet1. When Berkshire bought its 90% stake in Furniture Mart, it was able to add the assets of the furniture giant to its own balance sheet.
This presents a problem. Berkshire can now add the assets of Nebraska Furniture Mart to its balance sheet, but technically, it doesn't own them all. Remember, Rose Blumpkin only sold 90% of her company - she kept the other 10%. Berkshire will somehow have to show that some of the assets on its balance sheet belong to Rose, who has a minority interest in NFM. To do this, it will calculate the value of Rose's stake in the subsidiary and put it under a liability account called "Minority Interest". These are the assets Berkshire "owes" Rose.
A company may have several minority partners in many subsidiaries. The minority interest of all of these partners is added together and placed on the balance sheet.
1A company can integrate the balance sheet of its subsidiary if it owns 80% or more. It can report earnings of the subsidiary if it owns 20% or more.
Shareholder Equity
Shareholder Equity is the net worth of a company. It represents the stockholders' claim to a business's assets after all creditors and debts have been paid. Shareholder equity is also referred to as Owner's or Stockholders' Equity. It can be calculated by taking the total assets and subtracting the total liabilities.
Shareholder equity usually comes from two places. The first is cash paid in by investors when the company sold stock; the second is retained earnings, which are the accumulated profits a business has held on to and not paid out to its shareholders as dividends. Because these are the two ways a company generally creates shareholders' equity, the balance sheet is organized to show each parts' contribution.
Book Value
Book Value and Shareholder Equity are not quite the same thing. To find a company's book value, you need to take the shareholders' equity and exclude all intangible items. This leaves you with the theoretical value of all of the company's tangible assets (those which can be touched, seen, and felt). For this reason, book value is sometimes also called "Net Tangible Assets".
Net Tangible Assets (or Book Value)
The amount of net tangible assets a company has is particularly important. Since you should always analyze the balance sheet you get directly from the company (as opposed to the ones you find on Yahoo or other financial sites), you may not always have this figure calculated for you. To calculate it, take the total assets and subtract all of the intangible assets such as goodwill. What you are left with is the nuts and bolts of the company; the buildings, computers, telephones, pencils, and office chairs.
In the past, it was generally thought the more assets a company had the better. Over the past twenty years, value investors have come to reject this idea in its pure form; it is actually preferable to own a business that generates earnings on a lower asset base.
Why? Let's say your company earns $10 million a year and has $30 million in assets. My company earns the same $10 million but has $50 million assets. It is generally understood that a relationship exists between the amount of assets a company has and the profit it generates for the owners. If you wanted to double the earnings of your company, you would probably have to invest another $30 million into the company. After the reinvestment, the business would have $60 million in assets and earn $20 million a year.
On the other hand, if I wanted to double the earnings of my company, I would have to invest another $50 million into the business (which would double the assets). After the reinvestment, my business would have $100 million in assets and generate $20 million a year.
What does that mean?
You would have to retain $30 million in earnings to double your profits. I would have to retain $50 million to get the same profit! That means that you could have paid out the difference (in this case $20 million) as dividends, reinvested it in the business, paid down debt, or bought back shares! We will talk more about this in the future.
Balance Sheet 1: Microsoft
The main purpose of balance sheet analysis is to determine if a company is financially strong and economically efficient. The first balance sheet we are going to look at is a perfect example of both. It can be found in Microsoft's 2001 10K statement. (Note that an excerpt from the income statement is provided so you can calculate receivable and inventory turns). You need to keep this information in front of you as we analyze. I recommend you either print this page or open it in a new browser window.
Balance Sheet - 2001
(In millions)
30-Jun 2000 2001
Assets
Current assets:
Cash and equivalents $ 4,846 $ 3,922
Short-term investments 18,952 27,678
Total cash and short-term invest. 23,798 31,600
Accounts receivable 3,250 3,671
Deferred income taxes 1,708 1,949
Other 1,552 2,417
Total current assets 30,308 39,637
Property and equipment, net 1,903 2,309
Equity and other investments 17,726 14,141
Other assets 2,213 3,170
Total assets $52,150 $59,257
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $ 1,083 $ 1,188
Accrued compensation 557 742
Income taxes 585 1,468
Unearned revenue 4,816 5,614
Other 2,714 2,120
Total current liabilities 9,755 11,132
Deferred income taxes 1,027 836
Commitments and contingencies
Stockholders' equity:
Common stock and paid-in capital-shares authorized 12,000; shares issued and outstanding 5,283 and 5,383
23,195 28,390
Retained earnings, including accumulated other
comprehensive inc. of $1,527 &$587
18,173 18,899
Total stockholders' equity 41,368 47,289
Total liabilities and equity $52,150 $59,257
Income Statement
(In millions, except earnings per share)
Year Ended June 30 1999 2000 2001
Revenue $19,747 $22,956 $25,296
Operating expenses:
Cost of revenue 2,814 3,002 3,455
A Quick Note on Microsoft's Balance Sheet
Before we begin analyzing, notice that unlike most balance sheets, the most recent year is on the right hand side in bold. I highlighted the column so you would be sure to look at the correct figures.
An additional point: when companies put together their balance sheet, they tend to omit the 000's at the end of long numbers to save space. If you see on the top of a balance sheet that numbers are stated "in thousands", add "000" to find the actual amount (i.e., $10 stated in thousands would be $10,000). If a balance sheet is stated in millions, you will need to add "000,000" (i.e., $10 stated in millions would be $10,000,000).
Keep in mind we are analyzing the fiscal balance sheet as of June, 2001. This information may be different when you go to search on Moneycentral, Yahoo!, or TheStreet since they will use the most recent data available. The purpose of this analysis is not to advice you on what to buy, but rather to show you the process of analyzing a balance sheet.
Let's Begin Analyzing!
Cash Position
The first thing you will notice is that Microsoft has $31.6 billion in cash and short term investments. This doesn't mean much unless you compare it to the company's debt to find out if it is borrowed money. Glance down the balance sheet and look for any long-term debt. You'll notice there isn't an entry for it. This isn't a mistake; Microsoft has no long term debt.
Don't get too excited yet. Remember that some businesses fund day-to-day operations with short-term loans (think back to our department store executive at Christmas in Part 10). To see if Microsoft is using short term debt to survive, look at the current liabilities. In 2001, the entire value of Microsoft's current liabilities was $11,132. Compare that to the $31.6 billion in cash the company has. Does it have enough money to pay off its debt? Absolutely. Microsoft's balance sheet has 3x the cash necessary to pay off current liabilities and long term debt. This is without calculating in receivables and other assets. You can be sure the company is not in any danger of going bankrupt.
Working Capital
Let's calculate the company's working capital. Take the current assets ($39,637) and subtract the current liabilities ($11,132). The answer is $28,505. Microsoft has $28.5 billion in working capital. To find the working capital per share, look at the bottom of the balance sheet. You'll see there are 5.383 billion shares outstanding. Take the working capital of $28.5 billion and divide it by the 5.383 billion shares outstanding. The answer, $5.29, is the amount of working capital per-share.
If you could buy Microsoft's stock at $5.29 per share, you would be getting all of the company's fixed assets (real estate, computers, long term investments, etc.) plus its earnings / profit each year from now until eternity for free! The company will probably never trade that low; but you should always keep this in mind when analyzing a business. Sometimes, especially during serious economic downturns, you will find companies selling close to working capital. (Note: We will discuss stock option dilution and other advanced concepts in later lessons.)
Working Capital per Dollar of Sales
We calculated working capital at $28.505 billion. According to Microsoft's income statement, total revenue (the same thing as total sales) came to $25.296 billion. Following the formula for Working Capital per Dollar of Sales, we come up with 1.12 (or 112%). This means Microsoft has more working capital than its sales last year; if you remember from the lesson, manufacturers of heavy machinery require the most working capital and range from 20-25%. The 112% figure is excessive by anyone's standard. The main concern should not be financial safety, but efficiency. Why isn't Microsoft putting this money to work?
Current Ratio
The current ratio should be at least 1.5 but probably not over 3 or 4. Taking Microsoft's current assets and dividing them by the current liabilities, we find the software company has a current ratio of 3.56. Unless the business is saving resources to launch new products, build new production facilities, pay down debt, or pay a dividend to shareholders, a current ratio this high usually signals that management is not using cash very efficiently.
Quick Ratio
To calculate the quick ratio, we have to take the quick assets and divide them by current liabilities. If you've studied Microsoft's current assets, you will notice there is no entry for inventory. You know that Microsoft sells software; meaning its products consist of information It doesn't need to carry inventory. As soon as a customer places an order, the company can load its program onto a CD-ROM or DVD and ship it out the same day. Because there is no inventory, there is no risk of spoilage or obsolesce.
Inventory is what causes the biggest difference between the current and quick ratio. The quick ratio was designed to measure the immediate resources of a company against its current liabilities. Almost all of Microsoft's resources are already liquid. The only things that aren't are the $1.949 billion in deferred income taxes (how are you going to use it to raise cash?) and the $2.417 billion attributed to "other" current assets. Subtract these from the $39,637 billion in current assets and you get $35.271 billion. This $35 billion in quick assets represents the things the company can turn in to cash almost immediately. Divide it by the current liabilities ($35.271 divided by $11,132) and you get 3.168. Even under the most stringent test of financial strength, Microsoft has $3.168 in current assets for every $1 in liabilities.
Inventory Turn & Average Age of Inventory
We already discovered that Microsoft carries no inventory. It is absolutely efficient. Its products are already sold before they are manufactured.
Receivable Turn and Age of Receivables
You'll notice that on the income statement excerpt, credit sales is not listed as a separate item. Instead, we have to use the less accurate total sales or revenue figure to calculate receivable turn. Take the $25.296 billion in revenues and divide it by the average receivables, $3.4605 billion ($3250 + 3671 divided by 2). You will end up with 7.30 turns. To calculate the number of days this translate into, take 365 divided by 7.3. In Microsoft's case, the answer is 50 days.*
Debt to Equity Ratio
Microsoft is debt free. It has no long or short term debt. If you take $0 (the amount of the company's debt) and divide it by the shareholder equity ($47.289 billion) you will get 0. This means that 0% of the company's equity consists of debt; the shareholders own it all.
Final Thoughts
All of our calculations have shown one thing; the company has virtually no risk of bankruptcy. Microsoft has 3x the cash it needs to survive, no long term debt, no inventory to worry about, and extremely strong current and quick ratios. Its working capital per dollar of sales is 112%, excessive by any standard (especially compared to its competitors. Adobe Software had a ratio of 36%, while Oracle Systems came in at 46.5%). The main question an investor should ask when looking at the balance sheet is, "why so much cash?". None of the company's top management has given any clues as to the plans for the growing pile of greenbacks.
*You should generally calculate turns for the past several years, as well as between quarters. The numbers will almost always fluctuate during the normal course of business; regardless, a superior company will tend to have superior ratios over the long term.
Simon Transportation Services
Now that we've looked at an outstanding balance sheet, let's look at one that signals the company may be running into trouble. Simon Transportation is a trucking company that specializes in temperature-controlled transportation for major corporations such as Anheuser Busch, Campbell's Soup, Coors, Kraft, M&M Mars, Nestle, Pillsbury, and Wal-Mart. If you look closely, you will start to see problems develop in 2000 that foretell of future financial difficulties.
Simon Transportation Services, Inc.
Consolidated Balance Sheet - September 30, 2001
Assets
Current Assets 30-Sep-01 30-Sep-00
Cash and Cash Equivalents N/A $3,331,119
Short Term Investments N/A N/A
Receivables $36,495,339 $34,265,075
Inventories $1,302,067 $1,330,462
Prepaid expenses and other $2,528,675 $2,325,199
Total Current Assets $40,326,081 $41,251,855
Long Term Assets
Long Term Investments N/A N/A
Property, Plant and Eqp. $83,795,541 $49,403,534
Goodwill N/A N/A
Intangible Assets N/A N/A
Accumulated Depreciation (or Amortization)
N/A N/A
Other Assets $5,574,182 $451,603
Deferred LT Asset Charges N/A N/A
Total Assets $129,695,804 $91,106,992
Liabilities
Current Liabilities
Accounts Payable $46,031,588 $21,844,631
Short Term Debt $74,537,820 $3,437,120
Other Current Liabilities N/A N/A
Total Current Liabilities $120,569,408 $25,281,751
Long-Term Liabilities
Long Term Debt $835,000,000 $16,376,791
Other Liabilities N/A N/A
Deferred LT Liability ChargesN/A $4,604,318
Minority Interest N/A N/A
Total Liabilities $120,569,408 $46,262,860
Shareholder's Equity
Misc. Stock Option WarrantsN/A N/A
Redeemable Preferred N/A N/A
Preferred Stock $5,195,434 N/A
Common Stock $62,917 $62,877
Retained Earnings ($50,503,733) ($2,451,176)
Treasury Stock ($1,053,147) ($1,053,147)
Capital Surplus $51,865,007 $48,285,578
Other Stockholder Equity $3,559,918 N/A
Total Stock Holder Equity $9,126,396 $44,844,132
Income Statement
Total Revenue $278,818,242 $231,396,894
Cost of Revenue $253,268,462 $163,611,569
Simon Transportation Services
Simon Transportation Services filed for Chapter 11 bankruptcy in the early part of 2002. The company's balance sheet showed signs of strain almost two years prior. We are going to focus most of our attention on the 2000 part of the balance sheet to demonstrate that an intelligent investor could have seen warning signs before the company went under. Note: Since we are going to be focusing on 2000's numbers, we will not average in 2001's numbers to calculate inventory and receivable turn.
Cash Position
Simon had $3,331,119 in cash in September of 2000. It also had $3,437,120 in short term loans. This is the first sign the company was using borrowed money to operate. Almost all of the company's current assets are tied up in receivables, which is a real concern that customers may not be paying on time.
Working Capital
In 2000, the company had working capital of $15,970,104.
Working Capital per Dollar of Sales
In 2000, the company had total sales / revenues of $231,396,894. With working capital of $15,970,104, the company had a total Working Capital per Dollar of Sales percentage of 6.9%. Simon operates in the trucking industry, so most of its assets are fixed (in the form of diesels, trucks, semis, etc.)
Current Ratio
The current ratio should be at least 1.5 but probably not over 3 or 4. Simon had a current ratio of 1.631 in 2000. This is mediocre. The quick ratio will be a much better indication of the company's financial health.
Quick Ratio
The company's quick assets come out to around 1.487.
Inventory Turn & Average Age of Inventory
The company's inventory turn for 2000 only is 122.97 (meaning the company clears its inventory around every 3 days). In most situations, this would mean the company would have smaller working capital needs. However, if you look at the current assets, you notice they consist almost entirely of accounts receivable. Although the business sells its inventory frequently, it isn't converting those sales into cash immediately. Thus, the receivable turn is going to be very important to the success of this business.
Receivable Turn and Age of Receivables
Credit Sales are not carried individually. Thus, we will have to use the total sales / revenues of $231,396,894 with receivables of $34,265,075 in 2000. The receivable turn comes out to 6.75 times per year, or once every 54 days. So, although the company is clearing its inventory every 3 days, it is only getting paid every 54 days. Since the inventory turns aren't being converted to cash, the business needs more working capital. The 6% of working capital per dollar of sales we calculated earlier is dangerously low.
Debt to Equity Ratio
Combine Simon's short and long term debt, and you'll come up with $19,813,911. Divide the $44,844,132 in shareholder equity by this amount and you'll see that 44.18% of the company's equity is made up of debt. This would be acceptable if Simon enjoyed high enough return on equity to justify such a high borrowing level. A glance at the company's income statement shows that this is not the case; Simon lost money in 2000. Not only is the company not making money, it is losing money altogether. Common sense tells you that a business that is heavily in debt and is losing money probably isn't financially secure.
A quick look into the company's 10k and 10q statements reveals that the short term loans are secured by the receivables. In plain English, if Simon Transportation fails to pay its short term loans on time, the bank can go to court and take control of the receivables. If this were to happen, the business may not have enough cash on hand to pay its long term debt, which makes up a sizable part of the balance sheet. If Simon ran into a bump in the road, it probably wouldn't be able to survive because of cash flow issues.
Final Thoughts
Here's what we've observed: In 2000, a full year before declaring bankruptcy, Simon Transportation had very little working capital, barely acceptable current and quick ratios, a high percentage of debt to equity, and inventory that was quickly sold but slowly collected for. The company may be able to survive as long as it doesn't run into any problems. An increase in fuel prices, a driver strike, or some other unfavorable event that increased losses would quicken the company's financial demise. An item of particular concern is found in the company's 10k, "The Company's top 5, 10, and 25 customers accounted for 24%, 39%, and 57% of revenue, respectively, during fiscal 2000. No single customer accounted for more than 10% of revenue during the fiscal year."
According to these numbers, each of the top five customers accounted for nearly 5% of Simon's business. If just one of these switched to another trucking company, five percent of the business' revenues would have been lost. If the company had profitable with little or no debt, this would not be a concern. When you're counting on things going smoothly and you're playing with money that's not your own, you're almost always headed for disaster.
The bottom line: This is not a company you would invest in if you were looking for something long term and considerably safe.
Epilogue
On December 14, 2000, Simon issued a press release. It had run into a bump in the road. Here's an excerpt:
"In addition to the change in accounting method, during the quarter, Simon
experienced the highest driver turnover in its history. Turnover exacerbated
recruiting costs and contributed to increased claims and repair expense, and low
tractor utilization. In addition, high fuel prices continued to affect the
truckload industry, including Simon."
To correct this problem, Simon's management increased driver pay by 2¢ per mile, an increased cost the company could hardly afford. Perhaps most disturbing of all, the company openly acknowledged in its 10k around the same time that it was in violation of its long term debt agreements.
"The Company's secured line of credit agreement contains various
restrictive covenants including a minimum tangible net worth requirement and a
fixed charge coverage covenant. As of September 30, 2000, the Company was in
violation of the minimum tangible net worth requirement. The Company obtained a
waiver of the violation and as discussed in Note 10 has amended the covenant
subsequent to September 30, 2000."
In February of 2002, the company filed for Chapter 11 bankruptcy protection. Had an investor been able to analyze a balance sheet, they would have been warned in advance of the company's problems and possibly avoided huge losses to their portfolio.
2002 Joshua Kennon
[AM-HJQ6GH2]
The finance function now plays an increasing role in key decisions related to the business model and configuration of the business portfolio. Indeed, a new survey confirms that today's CFO responsibilities are akin to those of the CEO.
Vinay Couto and Gary Neilson
Financial Executive Magazine
29-July-2004
Describing today's financial executives as accountants and bean counters is as off-the-mark as walking into your local Starbucks and ordering a coffee in "small, medium or large." Over the past five to seven years, senior financial executives - beginning with CFOs - and their functional organizations have evolved well beyond the traditional roles of accountants and organizational police to become valued analysts and strategic business partners to senior management.
This has been such a complete transition that in many quarters it has gone unnoticed, yet it represents a major shift in terms of running business organizations of many sizes. Finance has become a place where business strategy, process and information combine and cross-pollinate.
Take a good look at your own organization, and you'll likely see finance involved in key decisions involving the design of the overall business model, as well as the configuration of the business portfolio.
Finance plays a role in developing responsive management architectures and governance structures, and is increasingly serving as a key integrator across the organization of process, technology and people. This is far different from the portfolio of the CFO and his or her direct reports just a decade ago. In fact, if you note these responsibilities are more akin to what you might expect of the chief executive officer, you're onto something.
A recent Booz Allen study looking into the "Organizational DNA" of business entities identified three main facts related to the finance function:
1) It was more tightly aligned internally than other support functions - human resources, information technology and marketing; 2) It tended to view business challenges in a similar way to senior management; and 3) It tracked more closely with line managers than other support functions in key areas.
Together, this supports a major evolution of the finance function - from analyst to catalyst. It also supports the much-evolved role of the CFO within the organization. In many cases, today's CFO serves as a chief lieutenant of the organization, particularly as the CEO is required to spend more time with the board of directors and the chief operating officer role continues to diminish in numbers and importance. The survey data demonstrate that finance is uniquely positioned to carry out this task.
We may or may not have entered the "Era of the CFO," but it is clear, both qualitatively and based on quantitative efforts, that the CFO and the CFO's organization have risen greatly in stature and responsibility. The CFO has DNA very similar to that of the CEO, and has built an organization that works from a similar viewpoint and understands the needs of the operating units in some very important ways. Whether this has helped drive the elevation of the CFO position or is a function of that evolution - or a little of each - is not entirely clear, nor does it particularly matter. The end result is the same, and we would argue vehemently that it is a positive step for overall performance.
The Nature of Finance
Finance, by its nature, reaches across and through any organization, whether a small company with a single business line or a major corporation with multiple business units. With such scope, it would be entirely natural for individuals within finance to begin to see the organization through the lens of their operating responsibilities. Thus, one might expect middle managers in finance to see the organization more like the other middle managers than their boss, the CFO. The same might be expected to hold true at the business unit and corporate staff levels.
The Booz Allen data disputes this hypothesis. Survey results show that finance-function DNA is quite strong and able to hew to its unique viewpoint far more than other support functions. The survey itself is based on the belief that individuals tend to view their organizations in distinct ways that say something about the quality of management - and performance - of those companies.
With this in mind, Booz Allen created an Internet questionnaire that allowed business leaders to describe their organizations based on 19 questions. Using proprietary software, the responses were used to classify their organizations into seven base DNA categories: 1) Resilient, 2) Just-in-Time, 3) Military, 4) Overmanaged, 5) Outgrown, 6) Fits-and-Starts, and 7) Passive-aggressive. Of these, the first three represent healthy organizations, though both the Just-in-Time and Military organizations carry with them certain weaknesses (see box).
There were responses from more than 4,000 business leaders by the time the data was analyzed to meet the deadline for this article. These included more than 650 finance function employees, of whom one-quarter were senior managers and another 3 percent were either line managers or middle managers. In terms of comparing the Organizational DNA for particular groups, such as the finance function broadly or finance within specific categories, we looked at the composition of the individual responses and the breakdown of the DNA categories those responses generated.
Finance as whole tended to have a more positive view of the organization than the non-finance respondents, based on a greater percentage of healthy DNA types.
The finance function's DNA looked like this:
Assessing the core DNA for finance as a whole, the differences between functions and organizational levels can be telling. For example, within the finance function, the top three healthy categories, Resilient, Just-in-Time and Military, add up to 31 percent, or nearly one-third of all responses. For non-finance functions, the same three categories totaled just 26 percent.
Looking at the finance function internally, similarities in the DNA profiles at different organizational levels speak to its ability to function in a uniquely smooth and efficient manner. When examining responses to individual questions within the survey, finance tends to see more eye-to-eye on business challenges, organization issues, decision-making dynamics and performance-measurement models than other support functions. This is demonstrated by a smaller variance of responses across all organizational levels - from staff to senior management - compared with responses from HR, IT and marketing.
Across organizational levels, the standard deviation of responses to the 19 survey questions within finance was the lowest of the support functions at about 6 percent. It was as high as 9 percent for human resources; IT and marketing fell in between. This suggests many things, including the great likelihood that as finance receives information from the business units, it creates less distortion as that information works its way up to senior management.
Elevating the CFO to 'Center Stage'
Such an interpretation would help explain the elevation of the CFO position and finance in general. With good information from all levels of the business, the CFO is in a position to give the CEO better counsel than others sitting at the senior management table. Clearly, we have seen the CFO move steadily in this direction, from an early focus strictly on finance to a seat on the executive committee, a position as trusted advisor to the CEO and, ultimately, a business partner of the chief executive.
This partnership is also supported by the other two key findings. Compared with other support functions, finance's view of the organization and its strengths is most similar to the senior executive view. On average, the finance organization's responses differed from that of senior managers by only 3.3 percent. HR, IT and marketing's responses differed from senior management's by 4.9 percent.
Further, when looking at the answers to individual questions, it is clear that finance aligns more closely with line functions - manufacturing and sales - than the other key support functions discussed here, HR, IT and marketing. Issues where the finance view more closely matched the line functions are those involving management responsibilities, the availability and flow of information and employee assessment issues.
Interpreting the organization's results and performance through the prism of a line organization, as opposed to a support function, suggests that finance is particularly attuned to operational issues, competition and the like. This, again, is a valuable resource in the executive suite and another reason why the CFO's fortunes have risen so markedly in the recent past.
Turn a TV on to business-news channel CNBC during any market day and you'll see a corporate executive on the screen describing his or her company's results. These interviews often take a 40,000-foot perspective on the company, and, increasingly the person giving the interview is the CFO.
We have clearly entered an era where the CFO has moved to center stage. CFO salaries can approach and exceed what the CEO was paid a decade ago. In an era of increased regulatory scrutiny and corporate governance concerns, the CFO takes on greater accountability and authority in his or her role in the more traditional finance functions of reporting and control.
Also, there are the new strategic responsibilities, where the CFO is more involved in identifying and focusing on the billion-dollar decisions of the organization. In many ways, the CFO has become an internal investment banker focused on creating enterprise value.
Facing the Challenges
From this summit, the CFO and the CFO's organization face new challenges as well. Finance is now responsible for providing business units with the information and knowledge they need to drive competitive advantage. This requires that they focus on obtaining better information, providing insightful direction to executive management, predicting and managing change, building relationships both internally and externally, taking a global perspective and, of course, continuing to reduce costs.
The CFO must possess or acquire new skills in order to fulfill this more demanding role, and must hire direct reports and others with a greater strategic perspective. In some cases, finance organizations have set up coaching programs to help upgrade the skills of their professionals. Some leading companies systematically rotate their finance staffers through the business units in order to gain greater understanding of the business from an operating perspective. This may, in fact, be a driver of finance's greater alignment with line functions, as demonstrated by the DNA survey.
Given the finance function's overall DNA, it is clear that the CFO and his or her organization are in a unique position to carry out two key responsibilities for the modern-day corporation. Finance is strongly positioned to act as a bridge between CEO and board, playing a major role in the overall corporate governance framework of the company. Second, finance is poised to step beyond the strengthened strategy and business-partner roles discussed earlier to become the company's chief corporate steward.
In an era where corporate trust has been badly eroded by scandals of all colors, these responsibilities are critical. They also provide great opportunities for those finance managers and executives who are willing to tackle them
[AM-13V49V4]
¶ 11:41 PM 0 Comments
The document further explains that a risk professional needs to be positioned high enough in that structure to ensure the success of the program, suggesting a high status for risk managers in different industries.
“Risk is inevitable in today’s business environment,” said IFRIMA president, Susan Meltzer. “It is time to get risk professionals in charge of mitigating the risks they are trained to identify and thereby leverage opportunities that benefit the whole of the company.”
According to the document, posted on www.ifrima.org, the value of risk management can and should be achieved by developing policies and activities in three significant areas:
1. Contribution to the overall business objectives of the organization.
All organizations must take risk in order to be successful. Risk management, appropriately applied, will allow the organization to take those risks, which are necessary to its overall value, and to leverage opportunities from the ability to take and manage risks.
2. Establishment of a consistent, transparent framework for corporate governance.
Good corporate governance requires that effective risk management programs be established by Boards of Directors and implemented by management. These programs must be comprehensive and transparent, promoting risk consciousness through the organization and allowing for comprehensive reporting externally to shareholders and regulators.
3. Protection for the company from adverse variances and catastrophes
Protection from adverse variances and catastrophes requires the consideration of both internal and external risk factors. In addition, to achieve appropriate protection requires a combined focus on risk mitigation and risk transfer through insurance, hedging or other financial instruments. The practice of hazard and insurable risk management has matured significantly over the years and has protected organizations from catastrophic risk exposures to their properties, personnel and for their liabilities.
IFRIMA does not intend to offer a risk management standard, but instead a best practices/guideline document.
“Risk professionals don’t fit into a certain mold,” Meltzer said, who also serves as Assistant Vice President of Risk Management at Sun Life Financial in Ontario. “Frankly, that is the intrigue of this profession for many of us. Across different industries, throughout different countries the job description varies tremendously.”
The best practices/guidelines suggest implementation of a plan congruent with the culture and mission of the organization. This includes:
1. Risk identification and assessment. This step includes identification of the significant risks that face the organization including development of risk registers and risk mapping along with both quantitative and qualitative analysis of the exposures facing the organization.
2. Risk mitigation strategies. The development of risk mitigation strategies is key to the management of risk issues and action plans need to be included in the overall business plans of the organization to ensure successful implementation.
3. Residual risk transfer. Once all risk mitigation strategies have been evaluated and implemented as appropriate, the residual risk has to be effectively managed through a combination of insurance, hedging and other alternative techniques ensuring the best possible coverage at the lowest possible transfer cost.
4. Risk reporting. The organization requires the ability to report on risks internally, specifically to senior management and the Board of Directors.
5. Monitoring. This part of the process is designed to ensure adherence to and effectiveness and relevance of policies and procedures relating to risk management.
The paper was approved at the IFRIMA Board of Director’s meeting in April 2004. The issuing of this paper comes at the end of a two year strategic planning period for IFRIMA, which is positioning itself as an active partner in the global risk management arena. IFRIMA supported a global risk management conference in Johannesburg, South Africa in October 2002 and formalized a process by which IFRIMA member organizations may apply to have their annual conferences be designated as IFRIMA worldwide conferences, at which IFRIMA will invite their delegation to attend. The next IFRIMA designated conference will take place September 7-10, 2004 in Bermuda in cooperation with ALARYS, the Latin American risk management association. Subsequent IFRIMA designated conferences will be the Federation of European Risk Managers Association (FERMA) conference in Lisbon in 2005 and the Risk and Insurance Management Society, Inc. (RIMS) 2006 Conference in Hawaii.
"These activities, and now this issuing of the ERM position paper, reinforces the role of IFRIMA as the leading organization, on a worldwide scale, in risk management and its application," said Maurizio Castelli, Chairman of IFRIMA and Group Risk Manager for Pirelli SpA in Milan.
###
The International Federation of Risk and Insurance Management Associations (IFRIMA) is the international umbrella organization for risk management associations representing 26 organizations and over 30 countries throughout the world. With its roots going back to the 1930s and its development through the discipline of insurance and risk management, IFRIMA is uniquely positioned as a leader in risk management and its application.
[AM-82TMDS] ¶ 9:35 AM 0 Comments
If you're going to run a race, it's wise to start with a strategy. That's a fact Michael E. Miller understands well. He's the CFO of Louisville, Ky.-based Churchill Downs Inc., which owns and operates six horse racetracks throughout the United States, including Churchill Downs, home of the Kentucky Derby.
In Miller's industry, cultivating customer loyalty and boosting revenue are challenging in any economic environment. But the trend in recent years away from on-site wagering on horse racing and toward off-track betting has added a new dimension to the problem. The customer relationship management (CRM) techniques that used to lead the race just aren't getting horse-racing businesses to the finish line today.
"It's a tough competitive environment. Without thoroughly understanding our customers and tailoring products and services to their specific needs and interests, it is difficult to maintain profitability," Miller says.
That's why Churchill Downs embarked on an ambitious initiative that should spur it well past the $424.2 million in revenue it brought in last year. Beginning in the mid-1990s, the company created newsletters and highly targeted online messages aimed at specific market segments. It developed a customer loyalty program. And it began holding sweepstakes to glean valuable customer data. Early this year, Churchill Downs implemented a CRM software package to bolster these programs. The system tracks and stores extensive information about customers' preferences. So, for example, if a particular bettor follows races for two-year-olds or has an affinity for turf tracks, the company most likely has that information in its CRM database. If a fan follows a particular lineage or has a favorite race, the organization probably knows that too.
Churchill Downs is not alone in turning to CRM projects to boost profitability. Over the past decade, "know thy customer" has become a mantra for all companies, large and small, as they struggle to cope with a tough marketplace and growing competition for customers and revenue. Few business technology initiatives in recent years have drawn more attention than CRM software implementations. Yet, despite the sophistication of these systems, many organizations' CRM efforts have an abysmal track record. Companies have consistently failed to transform raw data into a win.
And the situation isn't getting any better. "There is far too much emphasis on technology and not enough focus on constructing the right underlying business processes," explains Chris Selland, a vice president of sell-side research at Boston-based consulting and market research firm the Aberdeen Group. Success comes only when organizations truly understand how to take care of their customers. "Computers and software cannot think through that equation," he says.
Scott Nelson, a vice president of Gartner Inc. in Waukesha, Wis., believes that companies have focused so heavily on automating processes -- through self-service, call centers and sales force automation, for example -- that many have lost sight of CRM's primary objective. "The end goal," he says, "is to have a unified view of customers, understand which ones are the most faithful and valuable, and put together a plan to serve the various market segments effectively and profitably."
Customized Marketing
Getting beyond the software's glitzy features requires a focus on the business's fundamentals. Organizations that succeed with CRM initiatives view CRM technology as nothing more -- and nothing less -- than a means to achieve critical corporate goals.
That's the attitude of Michael Miller and his colleagues at Churchill Downs. When they confronted declining racetrack attendance and falling on-site revenues, they realized that a software tool could help them customize products and services to target the market segments that provide the bulk of the company's revenue. So they purchased a CRM analytics application from SPSS Inc. that tracks the interests and betting preferences of more than 1 million racing fans, including the 150,000 members of Churchill Downs' player-reward program, the Twin Spires Club.
The software enables Miller and his staff to sift through in-person, telephone and Web-based betting transactions. Then, using this data, they chart the demographic and psychographic patterns that drive customers' spending. This information enables the company to explore new ways to communicate with customers, including direct mail campaigns and personalized e-mail. Says Atique Shah, vice president of CRM and technology solutions for Churchill Downs, "We not only want to reach customers with the right offer, we want to reach them through the channel they find most appealing."
Satisfaction Drives Growth
Companies that invest time and money in developing a thorough understanding of their customers often realize significant benefits. Churchill Downs has already doubled the wagering outlays of some of its customers. Yet "many companies simply don't recognize who their customers are and what their preferences are," Selland notes. Without this knowledge, organizations face an uphill struggle to create policies and procedures that will generate long-term customer satisfaction and loyalty. And that can stunt a company's growth.
It's an issue Kevin B. Abbott has confronted head-on. He's the vice president, CFO and treasurer of Tustin, Calif.-based Toshiba America Medical Systems Inc., a provider of diagnostic medical imaging equipment. Five years ago, the company found itself trailing competitors in critical growth and customer satisfaction measures. "The first thing we had to do was understand why we weren't keeping up with the 10 percent growth rate that was taking place industrywide," Abbott says. "Our vision to be the leader in customer satisfaction, through the delivery of quality products and services, was not happening."
Toshiba America Medical Systems spent about 12 months conducting an in-depth evaluation of its customers and its internal customer management processes. The company discovered that it was losing a customer for every new one it picked up. The total cost of those losses amounted to between $50 million and $80 million a year, Abbott says. The reason for customers' malaise? They "felt that we had a superior product but that we were not providing the expected level of service and support," he reports.
In 2001, Toshiba America Medical Systems began using the data it had collected about customers' expectations to build a better CRM strategy. After developing software that could track accounts across departments, the company began sending its customers e-mail messages asking for feedback on the quality of its products and support. Sales reps were required to make a follow-up contact with the customer 90 days after each purchase, and the company sent out additional messages throughout the year, including some that sought to address specific problems and complaints. It also began measuring and monitoring customer attitudes and satisfaction rates on an aggregate level.
The results have been impressive. The company now enjoys a 70 percent customer retention rate. In customer surveys, the number of respondents who say that they will turn to Toshiba America Medical Systems for their next purchase has increased from 30 percent to 70 percent. The company is better able to predict when its customers will purchase new equipment. And most important, Toshiba America Medical Systems is now growing at a 23 percent annual rate, while the overall market for medical products is mired at 3 percent.
According to Abbott, the catalyst of the turnaround was the company's revamping of its business processes so that key departments could share data and work toward common goals. "After some initial resistance, people began to see just how valuable the system was and how it could improve our performance," he explains. "Instead of people working blind about who is out in the field supporting a client or what the status of an account is, everyone is now on the same page."
Unified Vision
According to Selland, the discipline of customer relationship management encompasses three functions: marketing, sales and customer service. It's like a three-legged stool; if a company neglects one of these areas, the entire structure collapses, he says. Unfortunately, organizations frequently fail to pay enough attention to all three areas. "Executives leading the various departments do not have a unified vision, and that results in a chaotic approach," he notes.
Nelson points out that, in some companies, a half-dozen departments may leave their fingerprints on even the most basic activities -- replacing a lost cellular phone or a broken part in a photocopier, for example. While several of a company's departments may monitor customer satisfaction individually, and each might achieve solid ratings, often "nobody bothers to look at the entire process and gather overall ratings," he says.
Ensuring that the organization's marketing, sales and support functions share key information is a large part of the CRM challenge. "It's important to get past the point where people feel they have ownership over data," notes Howard Lamb, chief technology officer in the Lexington, Mass., offices of management advisory firm Celerant Consulting. Companies should "build business processes that make data sharing possible -- even desirable -- and then put the software in place to make it happen," he says.
Employees in customer-facing functions must understand the organization's overall relationship with each of its customers; otherwise, a company can find itself selling large numbers of products to a customer that is a credit risk. Or it may miss opportunities for profitable repeat sales. If a service technician recognizes that a customer needs to upgrade or to buy a new product but fails to relay that information to a salesperson, a valuable sales opportunity will likely be lost.
In most cases, Lamb says, companies' CRM software initiatives fail because of faulty business processes and thorny cultural issues rather than implementation problems. "There is a large educational and training component to getting everyone on the same wavelength," he says. The system must support the organization's key performance indicators (KPIs). What's more, users must understand those measures and recognize how their actions -- and omissions -- affect the company's overall performance.
Healthy Results
When ISO Healthcare Consulting implemented a CRM software system from Salesforce.com in 2002, it gave equal attention to the technological and human sides of the CRM equation. The New York City-based health-care-strategy consulting firm, a subsidiary of Interpublic Group, needed to understand what individual sales professionals were doing to ensure that leads didn't fall through the cracks, and it wanted to provide CFO Michael LaRocco with greater visibility into future revenue and business swings.
In February 2002, ISO Healthcare Consulting moved into the CRM tool data that had previously resided in spreadsheets, in word processing files and on paper notepads. The system went live two months later. Today the firm's executives use the software to track the status of client accounts. The system sorts leads into four types: initial contacts by the sales team, contacts in which the client expressed interest in making a purchase, those in which the sales team estimates it has a 50 percent chance of closing the deal, and those in which the estimate is 90 percent.
Employees can use the system to access account information and notes about customers remotely -- for example, via wireless notebook PCs and personal digital assistants (PDAs) in the field. Real-time access to key data has translated into fewer missed opportunities and errors, and it has enabled ISO Healthcare Consulting to "leverage information to make better overall decisions," LaRocco reports. For instance, the CRM tool enables the sales team to access previous contracts online to help structure deals with new clients. LaRocco estimates that the software has cut the company's CRM costs by 75 percent by eliminating the need for an administrative assistant. In addition, it has generated a 25 percent time savings for the company's sales reps.
Despite success stories like those of ISO Healthcare Consulting, Churchill Downs and Toshiba America Medical Systems, the Aberdeen Group's Selland suggests that many organizations have invested too much money and time in CRM tools that are providing minimal results. "In many instances, companies need to reexamine technology and simplify processes to create greater consistency and develop a more global perspective," he notes. Adding technology to inefficient procedures can further muddle those processes, he points out, just as adding extra parts to a car engine can make it more complicated without improving speed or performance.
However, Gartner's Nelson underlines the value of technology in a CRM initiative. "Today's systems allow organizations to store, manage and leverage data in powerful ways," he notes. "Ultimately, it's about people dealing effectively with other people. It is essential to match results to expectations." Once a company understands that basic premise, it's in a far better position to transform a CRM software project from a technology initiative into a strategic plan.
4 Roadblocks
Customer relationship management (CRM) software initiatives fail for one or more of the following reasons, according to a December 2003 report titled "CRM Is Dead -- Long Live CRM" by advisory services firm Nucleus Research Inc.:
1. Poor planning. "Many companies deployed CRM [software] because they thought they needed CRM, not because they understood how technology would help cut costs, make users more productive or improve management," the report notes. "Like buying an airplane without a pilot's license, starting these projects without a clear plan destines them to remain on the tarmac -- or crash and burn."
2. Lack of an effective strategy to encourage adoption. Increased productivity is a key goal of many CRM software deployments. But these are complex tools, and the lack of a clear strategy for helping salespeople and support staff use them effectively can torpedo ROI.
3. Inadequate communication. Most CRM software implementations share certain key goals: They seek to identify customer service problems, pipelines for new sales and best practices. To achieve those objectives, the organization's various departments must communicate closely. Legacy policies of rewarding sales reps for individual accomplishments and "shooting from the hip" become an ankle weight when the company suddenly wants employees to share data and become team players.
4. Flawed strategic alignment. When the behavior of salespeople lacks alignment with the company's overall goals, CRM software initiatives are destined to fail. Too often, Nucleus reports, "management has toiled to get users to adopt CRM and enter enough data in systems so it would contribute positively to the organization." However, with executives pressing for solid financial results every quarter, sales reps' use of the software often diverges from what the organization strives for. For example, salespeople may use the tool to maximize their sales without ensuring that they fully meet their customers' needs and expectations.
Originally printed in the August 2004 issue of Business Finance
[AM-3DDXKQ2] ¶ 9:35 AM 0 Comments
In today’s business and economic environment, the practice of risk management has evolved to provide increasing value to organizations. Every organization takes risk in order to meet its business objectives. Without risk, there would be no reward. The risks that an organization takes must be assumed through a disciplined and systematic approach to risk management in order to add value. Not only does risk management protect the organization from loss, but also the appropriate risk management techniques will allow the organization to take those risks necessary to meet its business objectives.
Risk Management is a central part of any organization’s strategic management. It is the process whereby organizations methodically address the risks relating to their activities, with the goal of achieving sustained benefits across the portfolio of activities. Risk management should add maximum value to these activities. In order to properly integrate risk management into the strategic management of the organization, the risk manager must be positioned at a high enough level in the organizational structure to ensure the success of the program.
The value added by risk management relates directly to the mission of the organization, its long-term viability and its business imperatives. In order to achieve this value, risk management can and should be applied by taking an integrated approach, i.e.:
> Taking into consideration all types of risks
> Adopting a consistent approach and methodology to each type of risk
> Ensuring that policies and strategies are developed with a positive and professional risk/opportunity approach.
This can and should be achieved by developing policies and activities in three significant areas:
1. Contribution to the overall business objectives of the organization.
All organizations must take risk in order to be successful. Risk management, appropriately applied, will allow the organization to take those risks, which are necessary to its overall value, and to leverage opportunities from the ability to take and manage risks.
2. Establishment of a consistent, transparent framework for corporate governance.
Good corporate governance requires that effective risk management programs be established by Boards of Directors and implemented by management. These programs must be comprehensive and transparent, promoting risk consciousness through the organization and allowing for comprehensive reporting externally to shareholders and regulators.
3. Protection for the company from adverse variances and catastrophes
Protection from adverse variances and catastrophes requires the consideration of both internal and external risk factors. In addition, to achieve appropriate protection requires a combined focus on risk mitigation and risk transfer through insurance, hedging or other financial instruments. The practice of hazard and insurable risk management has matured significantly over the years and has protected organizations from catastrophic risk exposures to their properties, personnel and for their liabilities.
Risk management standards have been developed and adopted by IFRIMA members in Australia, Europe and Canada. Corporate governance regulations have been developed by a number of governments and stock exchanges throughout the world. In addition, industry and risk specific standards, guidelines and frameworks have been developed by many professional and self-regulatory organizations, such as the Committee of Sponsoring Organizations (on behalf of the audit profession), the Basel Accord for banking institutions and the Global Association of Risk Professionals (on behalf of financial risk managers.)
IFRIMA encourages the development of best practices and guidelines for risk management. A detailed international risk management standard would not be practical to develop because there is no one risk management standard. However, a generic best practice/guideline document is considered by IFRIMA as beneficial for the development of risk management throughout industries and countries.
The foundation of a strong risk management program is the inclusion of a disciplined, consistent process throughout an organization. That process needs to be linked to the organization’s strategic objectives and should include:
1. Risk identification and assessment. This step includes identification of the significant risks that face the organization including development of risk registers and risk mapping along with both quantitative and qualitative analysis of the exposures facing the organization.
2. Risk mitigation strategies. The development of risk mitigation strategies is key to the management of risk issues and action plans need to be included in the overall business plans of the organization to ensure successful implementation.
3. Residual risk transfer. Once all risk mitigation strategies have been evaluated and implemented as appropriate, the residual risk has to be effectively managed through a combination of insurance, hedging and other alternative techniques ensuring the best possible coverage at the lowest possible transfer cost.
4. Risk reporting. The organization requires the ability to report on risks internally, specifically to senior management and the Board of Directors.
5. Monitoring. This part of the process is designed to ensure adherence to and effectiveness and relevance of policies and procedures relating to risk management.
Implementation of a risk management program will differ from one organization to another. Nevertheless, it is important that the implementation plans include the manner in which risk management will be embedded into the culture of the organization. This should include the definition of roles, training and integration into the reward system. Without operationalizing risk management into the organization’s culture, the program will become just words on paper.
The skill set for risk management will vary considerably depending upon the industry. It can include the need for expertise in investments, finance, actuarial science, law, engineering, risk transfer, business processes, internal audit, etc. including combinations thereof in order to appropriately address the risks. Risk management is a collaborative process requiring commitment and consensus within an organization. The culture and business purpose of the organization will drive the type of process and risk mitigation strategies to ensure successful implementation.
[AM-NXRP2C4] ¶ 9:34 AM 0 Comments
You see the ads all the time: "Make millions now, no manager" or "Work on your own, start $12,000 per week." Maybe you saw the ad in the paper, or maybe you received it by e-mail.
Yes, we're talking about Multi-Level Marketing, also known as "MLM"
MLM: Once Legitimate, Now a Scam
Once upon a time, multi-level marketing was a legitimate business which provided a way for small companies to get their unique products to consumers in small towns and rural areas which had no access to these products. At this time, the products sold themselves, and the multi-level aspect was a way of giving a small reward to those who had worked hard to build the organization. But the focus was always on the product.
Today, and especially with the growth of the internet, it is possible for consumer to get about whatever they want at competitive prices. There is simply no real need for distribution "systems" as there once was, and indeed the focus of all the programs is not on the products they sell -- which are usually either bogus or are available somewhere else to the public at the same or lesser prices. Instead, the focus now is solely on recruiting new people to either buy into the program or else to buy products that are grossly overpriced (i.e., a $1 bottle of "herbal shampoo" for $26), with the idea that those people will recruit additional people who will also buy into the program or themselves buy the grossly overpriced products.
Thus, today just about ALL of the multi-level marketing programs are scams. In today's internet economy, there is simply no need for multi-level marketing or the overpriced products that they sell -- meaning that the only thing they are selling are memberships in anticipation that future memberships will be sold in the future, which is the classic definition of a pyramid scheme, and thus securities fraud.
Because products are available over the internet to everybody at lower costs than ever before, claims that "Multi-Level Marketing will take over the World!" are completely bogus. Indeed, the fact that no MLM schemes sell significant product to anybody other than the people who bought into the programs is proof positive that MLM is a dinosaur in today's economy, and exists only by defrauding people to buy memberships in anticipation of being able to make a profit defrauding other people into the program.
Indeed, as is discussed elsewhere, many of these programs have been broken up for securities fraud and the people in them now have criminal records. So, save your Quatloos and avoid MLM schemes.
Stars! Stars!
Like many advertising campaigns, many MLM programs now attempt to associate themselves with celebrities. "Zig Ziglar goes MLM!" read one spam e-mail we received.
Note that the celebrities didn't make their money in MLM. Nor will you.
Buying Into the Program
So you are being "hired" to sell products, and you have to buy into the program? This is a sure sign that it is a scam. If the product is worth a darn, the company will make its money selling the product. No program that requires you to buy into the program is real, meaning that all our scams.
If you have to buy into the program, forget it! It is not a real program.
Sales Material
Often MLM scams have sub-scams within the main scam of buying Distributorships. One of these scams is the purchasing of advertising materials. Think about it: A company wants you to sell their product but they want you to pay for the advertising materials? Especially with the huge profit margins that the Top Guy makes with these programs, they should at least pay for your brochures and tapes. If a company requires you to pay for advertising or marketing materials, it is a sure sign that it is a scam. The very worst programs will even require you to buy the "samples" of the product that you have paid to be able to sell!
Training Seminars
A scam-within-the-scam is the "training seminars" offered (sometimes required) by the MLM programs. These "training seminars" offer little training, but are mostly rah-rah seminars to boost enthusiasm -- and to make big bucks for the promoters. We have often seen people encouraged to take out thousands of dollars in credit card debt to go to these seminars, with the promise that they will make so much selling the MLM program that they will quickly pay back the credit card debt (this is almost never true).
These training seminars can cost thousands although the company ought to be paying you to attend and learn how to sell its product. No company which requires you to pay for your own training seminar is a real program.
Only The Top People Make Money
The hard truth is that only the guy who sets up the program, i.e., the Big Cheese at the very top, makes any really good money with these programs. Everybody who is selling for the Promoter typically gets screwed.
Nonetheless, the promoters of these programs will often have pictures of themselves standing next to their mansion, yacht, executive jet, whatever, to show their success. Yes, these are real and they did make money by selling programs. Unfortunately, they made this money by cheating and defrauding the people under them to sell these programs for them -- you never see a distributor with anything other than a bunch of credit card debt.
The Drop Out Rate
The "Drop Out Rate" of MLM programs is enormous -- 98% will drop out immediately, meaning that only 2% will continue with the program over any long period of time. The Promoters will tell this 2% that they are the "successful" ones -- what this means is that they have become "successful" scamming other people (who will probably spend their money and then drop out, possibly a big personal loss to them but a profit to the Promoters).
The Promoters know the Drop Out Rate, and know that by far most people will buy in, but then never sell anything and quit, which is one of the reasons why MLM programs are criminal schemes.
The Promoters also tell those who stay in that they are the "well-motivated and lucky ones". This is 100% false. The people who never sold anything and dropped out are the lucky ones, since they will not be liable for securities fraud or any of the related criminal penalties that goes with promoting somebody else into the program. It is the people who stay in the program who are risking some prison time and a felony conviction for selling an unregistered security.
One of the biggest problems of MLM is that they are marketed to people who are down-and-out and desperate, and who can ill-afford to lose their money by purchasing memberships in these bogus programs.
You Gotta Believe!
Promoters tell prospective Distributors that to be successful "You gotta believe!" in the program. This is part of a brainwashing/programming effort to lead you to believe that you will fall into that (falsely) "successful" 2% if you believe in the program and the products that it sells. Thus, active Distributors will defend to great lengths their program and their products, to the point of slandering naysayers, spamming "negative" or competing sites with e-mail to shut them down, threats of physical harassment, etc., etc., not to mention often buying the products themselves in substantial quantity.
But the proof is in the pudding. It is an interesting phenomena of MLM that the hardcore and brainwashed Distributors who defend the products the hardest, almost always quit using those "great products" completely when they move on to the next program!
The point of this is that the 2% of "successful" Distributors have usually been brainwashed and programmed so that they really believe the junk they are saying about the junk they are selling. But that doesn't make it any less junk.
Building that Downline
- As discussed above, the 98% drop-out rate means that you probably will never build a significant downline.
- None of these programs last very long (Amway seems to be the sole exception), meaning that as soon as the program croaks your revenue stops.
- The odds of anybody in your downline making any money are incredibly small (smaller than yours!), meaning that they will probably "drop out" and be mad at you for getting them into a program where they lost your money -- the upshot being that these people will certainly not follow you to your next program (which will be necessary when your existing program finally collapses), meaning that you will have to build a completely new downline with every new program!
The promise of MLM is that if you are "successful" (in defrauding others) that you will create this big "downline", i.e., multiple layers of sellers under you, which will quickly lead you to riches and allow you to retire forever with a never-ending stream of seven- or eight-figure revenue.
This promise is totally fraudulent, for at least the following reasons:
For all these reasons, your chances of long-term residual income with MLM is zero. Even if you are successful, the best you can hope for is a lot of hard work defrauding others to build your downline, some short-term profits until your program collapses or is shut down, and then a lot more hard work defrauding even more people into your next program, and so forth and so on until you get sick of it and drop out of MLM completely.
Buying Your Own Products
To the extent MLM programs sell any product, it is usually purchased by people who -- frustrated by their ability to build a downline and pressured by their recruiters -- will themselves buy mass quantities of the product as an attempted badge of "success". Thus, newbies on the lowest levels will max out their credit cards and buy lots of worthless product themselves in a vain attempt to move on to the next level. Usually, this works only if there is a "buy in" to the next level (more Quatloos for the promoters!) but never means success to the poor sucker buying the products, although he or she will end up with a closet full of vitamins, shampoo, phone cards or whatever -- and usually a lot of credit card debt too.
Fake It 'Til You Make It
Buying your own products is just one aspect of the MLM method of "Fake It 'Til You Make It", meaning that even if you are having zero success, you should act like you are very successful and have already made the Big Time. Many programs will tell people to start living a high lifestyle (on their own credit cards, of course), go lease a new BMW, etc., etc., so that people will believe that you are successful and they will then want to be in the program too.
The problem of course is that only a small percentage are successful in MLM, and these only for the short time until their program collapses. Their debts and BMW leases, however, are long term and require monthly payments to maintain. We have spoken with a few people who were encouraged by Promoters to lease expensive cars, and then were forced to actually live in those cars because they couldn't make the rent (and of course the cars were eventually repo'd from them too, leaving them homeless).
Additionally, the "Fake It 'Til You Make It" is just more fraud on the people you are trying to bring in. Acting like you are making the Big Bucks when you are not is blatanly dishonest -- but all part of the MLM scheme of cheating people.
Heavy-Hitters
A variation of "Fake It 'Til You Make It" is the "Heavy-Hitter" who bounces on the scene and seems very rich, and then acts as a "closer" of new recruits. Whether or not the "Heavy-Hitter" will actually have any money is subject to serious doubt: He may be one of the people living out of his leased BMW! More likely, he has been hired on a pure salary basis by the Promoters to act as a cheerleader and "closer" for prospective Distributors.
The "Heavy-Hitters" usually circulate from program to program, and are often the "Heavy-Hitter" in several MLM programs at the same time. A good way to identify these scam artists is to inquire as to what other programs they are in now, and have been in the future. If they have been in several other programs, you know that you are facing a "Heavy-Hitter", which when you get down to it is just a professional MLM scam artist (and, again, probably on a flat salary no matter what BS they tell you).
At seminars, you will frequently hear the Heavy-Hitter buildup: "Maybe Mr. Such-And-Such" will be here today!" The excitement is such that when Mr. Such-And-Such finally appears, you'd think Moses just came down from the mountain. It is all hype: The Promoters know exactly who will be at these seminars, and they plant people in the audience to make statement such as these, so that Mr. Such-And-Such finally does make his appearance, people attribute to him the credibility of the Messiah. Don't fall for this ruse.
For reference, the "Heavy-Hitter" is not unique to MLM. Casinos have for many years employed "Shills", being people who are hired by the casinos on salary and given a bunch of chips, and sent into the casino to mingle with the other gamblers and spin a few stories of the casino's big payoffs (which may or may not have occurred) -- and of course to gamble the (casino's own) chips and thus encourage others to gamble with the same enthusiasm and similar better levels.
The "Heavy-Hitters" perform the same function with MLM, often coming in to tell false stories about themselves hitting it big with the program. You can admire their gold pinkie rings, and their expensive leather shoes. But avoid these people, and just chuckle at the stories they sell. And be sure to ask them about the lease program on that BMW they are driving!
Fending Off Criticisms
You may see your program mentioned in an unfavorable light, such as on 60 Minutes or 20/20 or some other investigative news program. The Promoters will tell you something like "Their job is to bring down good companies . . .." Bull! Their job is to point out scams, and if your program has been featured on one of these program you can pretty much be sure it is one (if it is an MLM program it is a scam whether it is featured on these programs or not).
Survival Mode
After you have made big investments into the MLM program (or maybe several), are strung out on your credit cards, and the program isn't working out, then you will go into what is called "Survival Mode", where you finally give up the (false) dream of big riches with MLM and start trying to figure out how to hold off your credit card companies while getting back to a normal lifestyle.
Unfortunately, we don't have any special advice to offer. The only thing that we can say is that suicide shouldn't be an option (ex-MLM'ers unfortunately have a very high suicide rate), and that you should simultaneously seek credit counseling, and maybe adult education for re-education for a better job.
Refunds
The worst programs will promise you some sort of refund if it all doesn't work out. These are the worst programs because the refund programs are usually contingent on this-or-that, require long forms and long waits, often the refund is only 30% or so of what you spent, and usually the refunds are illusory (meaning that they company will never pay out the refund to you). The MLM programs which offer refunds do this to create the illusion that there is "no risk" to you -- and this is a 100% fraud because as discussed, you odds of actually getting your money back is infinitesimally small.
At least the companies which don't offer refunds tell you this up front so that you are not suckered into believing this nonsense
LINK:
MLM Watch: A Skeptical Guide to Multilevel Marketing -- A Skeptical Guide to Multilevel Marketing -- From the people who brought you Quackwatch comes an excellent collection of articles and links about MLM, hosted by Stephen Barrett, M.D.
The Best Links
- http://www.amquix.info/amway.html -- OUTSTANDING -- Amway/Quixtar Business Myths. If you want a peak at the "inside" of the largest and longest running MLM program, check out Scott Larson's extensive website.
- http://www.vandruff.com/ mlm.html and http://www.vandruff.com/ mlm_FAQ.html -- HIGHLY RECOMMENDED -- Series of pointed and on-point articles about MLM.
- http://www.worldwidescam.com -- HILARIOUS lampooning of some of the worst MLM programs.
Other Good Links
- http://www.mlmsurvivor.com - MLM Survivor
- http://dcn.davis.ca.us/ ~btcarrol/ skeptic/ mlmhar.html -- The Skeptic's Dictionary takes on MLM.
- http://www.ftc.gov/bcp/ conline/pubs /invest/mlm.htm -- Federal Trade Commission warning about MLM scams.
- http://cageyconsumer.com/ mlminfo.html -- The Cagey Consumer takes on MLM.
- http://www.getfacts.com/ amway -- A critical discussion of Amway.
- http://members.aol.com/ multisense/ home.htm -- MultiSense candidly discusses MLM.
- http://members.tripod.com/ ~nomorescams/ fitzpatrick.htm -- MLM Survivor's Homepage: The 10 Big Lies of Multi-Level Marketing.
- http://www.metroactive.com/ papers/ metro/ 10.03.96/ cover/ multilevel-9640.html -- Interesting article called "Shaking the Money Tree"
- http://www.newwave.net/ ~poohbear/ chaching/ index.html -- Article "Is Your Church A Marketplace" discusses use of religion to sell MLM schemes.
- http://www.quackwatch.com/ 01QuackeryRelatedTopics/ mlm.html -- Quackwatch article: The Mirage of Multi-Level Marketing.
- http://www.usps.gov/ websites/ depart/ inspect/ pyramid.htm -- U.S. Postal Inspection Service warning about MLM.
- http://www.whatisgood.com/nwm/ -- Consumer Awareness Institute study of MLM.
More information about MLM is on its way! In the interim, please send us your comments about our MLM page to us at our Tony-the-Wonder-Llama Form
[AM-KNTHT54]
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