Total debt ÷ Capital = Debt-to-capital ratio
To show you how to calculate the debt-to-capital ratio, I use the information from Mattel’s and Hasbro’s 2007 balance sheets.
Mattel
First, to find out Mattel’s total debt, add up Mattel’s short-term and long-term debt obligations:
Short-term borrowings $349,003,000
Current portion of long-term debt $50,000
Long-term debt $550,000,000
Total debt $949,003,000
Next, add the total debt to total equity to figure the number for capital:
$2,306,742,000 (Equity) + $949,003,000 (Debt) = $3,255,745,000 (Capital) Finally, calculate the debt-to-capital ratio:
$949,003,000 (Total debt) ÷ $3,255,745,000 (Capital) = 0.29 (Debt-to-capital ratio)
So Mattel’s debt-to-capital ratio was 0.29 to 1 in 2007.
Hasbro
First, to find out Hasbro’s total debt, add up Hasbro’s short-term and long- term debt obligations:
Short-term borrowings $10,201,000
Current portion of long-term debt $135,348,000
Long-term debt $709,723,000
Total debt $855,272,000
Then add the total debt to total equity to find out the number for capital:
$1,385,092,000 (Equity) + $855,272,000 (Debt) = $2,240,364,000 (Capital) Finally, calculate the debt-to-capital ratio:
$855,272,000 (Total debt) ÷ $2,240,364,000 (Capital) = 0.38 (Debt-to- capital ratio)
So Hasbro’s debt-to-capital ratio was higher than Mattel’s at 0.38 to 1.
What do the numbers mean?
Lenders often place debt-to-capital ratio requirements in the terms of a credit agreement for a company to maintain its credit status. If a company’s debt creeps above what its lenders allow for the debt-to-capital ratio, the lender can call the loan, which means the business has to raise cash to pay off the loan. Companies usually take care of a call by finding another lender. The new lender will likely charge higher interest rates because the company’s higher debt-to-capital ratio makes the company appear as though it’s a greater credit risk.
Generally, companies are considered to be in good financial shape with a debt- to-capital ratio of 0.35 to 1 or less. If a company’s debt-to-capital ratio creeps above 0.50 to 1, lenders usually consider the company a much higher credit risk, which means it has to pay higher interest rates to get loans.
Take note of the ratio and how it compares with the ratios of similar compa- nies in its industry. If the company has a higher debt-to-capital ratio than most of its competitors, lenders will probably see it as a much higher credit risk.
A company with a higher than normal debt-to-capital ratio faces an increasing cost of operating as it tries to meet the obligations of paying higher interest rates. These higher interest payments can spiral into more significant prob- lems as the cash crunch intensifies. In a worst-case scenario, the company can seek bankruptcy protection from its creditors to continue operating and to restructure its debt. Many times its stock value plummets and may have no value left at all if the company emerges from bankruptcy.
Making Sure the Company Has Cash to Carry On
In This Chapter
▶ Determining a company’s solvency
▶ Gauging financial strength by looking at debt
▶ Checking cash sufficiency
No business can operate without cash. Unfortunately, the balance sheet (see Chapter 6) and income statement (see Chapter 7) don’t tell you how well a company manages its cash flow, which is critical for measuring a company’s ability to stay in business. To find this important information, you need to turn to the statement of cash flows, also known as the cash flow state- ment, which looks at how cash flows into and out of a business through its operations, investments, and financing activities.
In this chapter, I show you some basic calculations that help you determine the cash flow from sales and help you find out whether the cash flow is suf- ficient to meet the company’s cash needs. Throughout the chapter, I use Mattel and Hasbro (two leading toy companies) as examples to show you how to use these tools to evaluate a company’s financial health. You can find Hasbro’s financial statements, as well as its complete annual report, at www.
hasbro.com and Mattel’s at www.mattel.com.
Measuring Income Success
Looking at whether a company is generating enough cash income can help you determine the company’s solvency — its capability to meet its financial obligations (in other words, its ability to pay all its outstanding bills). If a firm can’t pay its bills, its creditors won’t be happy, and it could be forced to file bankruptcy or discontinue operations. In this section, I show you two ratios that can help you determine a company’s solvency based on its sales success.
Calculating free cash flow
The first step in determining a company’s solvency is to find out how much money the company earns from its operations that can actually be put into a savings account for future use — in other words, a company’s discretionary cash. This is also called the free cash flow.
A business with significant cash flow has a lot of flexibility to decide whether it wants to use its discretionary cash to purchase additional investments, pay down more debt, or add to its liquidity, which means to deposit additional funds in cash and cash equivalent accounts (including checking accounts, sav- ings accounts, and other holdings that can easily be converted to cash). The formula for calculating the free cash flow is a simple one:
Cash provided by operating activities – Capital expenditures – Cash divi- dends = Free cash flow
Cash flows from operating activities can be found at the bottom of the operat- ing activities section of the statement of cash flows. Capital expenditures can be found in the investing activities section of the cash flow statement. Cash dividends paid can be found in the financing activities section of the statement of cash flows.
Mattel
Using Mattel’s 2007 and 2006 cash flow statements, I show you how to calcu- late the free cash flow:
2007 2006
Cash provided by operating activities
$560,532,000 $875,946,000 Minus capital expenditures
Purchases of tools, dies, and molds
(68,275,000) (69,335,000) Purchases of other property,
plant, and equipment
(78,358,000) (64,106,000) Minus cash dividends (272,343,000) (249,542,000)
Free cash flow $141,556,000 $492,963,000
As you can see, Mattel’s free cash flow dropped significantly from 2006 to 2007, by a total of about $351 million. The $23 million increase in dividends explains part of that drop, but more noteworthy is that Mattel’s cash pro- vided by operating activities dropped by about $315 million. Taking a closer look at the cash flow from operating activities section, you can see a signifi- cant reduction in cash flow related to Mattel’s inventory line item (I show
you how to investigate this number in Chapter 15). You also see a decrease in cash because $311.9 million was paid out in accounts payable, accrued liabili- ties, and income taxes payable. I show you how to analyze accounts payable in Chapter 16.
Clearly, Mattel is having trouble maintaining its previous cash levels. That could mean that the company decided to maintain lower cash levels and invest in new opportunities, or it could mean that it’s having difficulty gener- ating new cash. But you can’t determine that with this calculation — it tells you that the company may have a problem, but it doesn’t give you a specific answer as to what the problem may be. What you do find out from this for- mula is that you must seek additional information by continuing the financial analysis of other line items (such as accounts receivable and inventory) and by reading the notes to the financial statements (see Chapter 9) or manage- ment’s discussion and analysis (see Chapter 5).
Hasbro
Now I show you how to calculate the free cash flow by using Hasbro’s 2007 and 2006 cash flow statements.
2007 2006
Cash provided by operating activities
$601,794,000 $320,647,000 Minus capital expenditures
Purchases of property, plant, and equipment
(91,532,000) (82,103,000)
Minus cash dividends (94,097,000) (75,282,000)
Free cash flow $416,165,000 $163,262,000
Hasbro’s free cash flow is much stronger than Mattel’s for 2007. Also, Hasbro’s free cash flow increased from 2006 to 2007. This means that Hasbro has no trouble maintaining its cash-flow levels and actually improving its cash flow.
What do the numbers mean?
No question, the more free cash flow a company has, the better it’s doing financially. A company with significant free cash flow is in a strong posi- tion to weather a financial storm, be it a recession, a slowdown in sales, or another type of financial emergency.
If a company’s free-cash-flow number is negative, it must seek external financ- ing to fund its growth. Negative or very low free-cash-flow numbers for young growth companies that need to make significant investments in new property, plant, or equipment are most likely not an indication of a big problem. But you
should still look deeper into the financial reports, and especially the notes to the financial statements (see Chapter 9), to find out why the cash flow is so low and how the managers plan to raise additional capital. This is especially true if you see a negative free cash flow for an older company, which should immediately raise a red flag.
Figuring out cash return on sales ratio
You can test how well a company’s sales are generating cash using the cash return on sales ratio. This ratio looks at profitability from cash rather than from the accrual-based income perspective. Remember, the accrual-based income perspective means that income and expenses are recognized when the transaction is complete, so there’s no guarantee that cash has been received. I talk more about this in Chapter 4.
Making sure a business is properly managing its cash flow is critical when assessing the company’s ability to stay in business and pay its bills. Sales are the primary way a company generates its cash.
Here’s the formula for calculating the cash return on sales ratio, which spe- cifically measures cash generated by sales:
Net cash provided by operating activities ÷ Net sales = Cash return on sales
You can find the line item “Net cash provided by operating activities” on the cash flow statement in the operating activities section, and you find “Net sales” or “Net revenue” at the top of the income statement.
Mattel
I use Mattel’s cash flow and income statements to show you how to calculate the cash return on sales ratio:
$560,532,000 (Net cash provided by operating activities) ÷ $5,970,090,000 (Net sales) = 9.4% (Cash return on sales)
From looking at this equation, you can see that 9.4 percent of the dollars that Mattel generates from its sales provide cash for the company. Mattel’s net profit margin (the bottom line, or how much the company makes after all costs and expenses are subtracted), which I show you how to calculate in Chapter 11, is 10.05 percent. Mattel’s cash return on sales is slightly lower than its net profit margin. Although the difference isn’t significant, you do need to investigate the numbers more closely. As indicated above, Mattel’s inventory generated less cash in 2007 than in 2006. Also, significantly more was paid out in accounts payable, so that may be why the warning signs are here. You’ll know more after looking at the numbers in Chapters 15 and 16.
Hasbro
Using Hasbro’s cash flow and income statements, I show you how to calcu- late the cash return on sales ratio:
$601,794,000 (Net cash provided by operating activities) ÷ $3,837,557,000 (Net sales) = 15.7% (Cash return on sales)
You can see that 15.7 percent of the dollars that Hasbro generates from its sales provide cash for the company. Hasbro’s net profit margin is 8.68 per- cent (see Chapter 11), which is a strong sign that Hasbro is efficiently con- verting its sales to cash.
What do the numbers mean?
The cash return on sales looks at the efficiency with which a company turns its sales into cash. Hasbro’s results show that it’s more efficient than Mattel at turning its sales dollars into cash. Add the fact that Mattel’s cash flow was negatively impacted by decreases in cash from inventory (see “Calculating free cash flow,” earlier in the chapter) and you get a clearer picture that Mattel may have a problem converting its sales to cash. In Chapter 16, I discuss how to evaluate a company’s accounts receivable turnover, which explains some of these cash problems.
Mattel’s cash return on sales is slightly lower than its profit margin, so the company may be showing the early signs of a problem or the strains of the toy recall in 2007, when problems in China may have cut significantly into profits.
Just bear in mind that a cash return on sales ratio that’s lower than the profit margin ratio can be a major red flag. The company may be using aggressive accrual accounting practices that enable it to report higher net profit. I dis- cuss these types of practices in Chapter 23.
Checking Out Debt
In addition to noting how much cash a company generates from sales, you need to look at the cash flow going out of the company to pay its debts.
Whenever a business can’t pay its bills or the interest on its debt, it runs the risk of supply cutoffs and possible insolvency. Few vendors will continue sending products to a company that doesn’t pay its bills, and most creditors will seek ways to collect a debt if they don’t receive the interest and principal due on that debt.
You can check out a company’s ability to pay its debt by looking at its debt levels and the cash available to pay that debt. You do this by collecting num- bers related to debt levels from the balance sheet and comparing them with cash-outflow numbers from the statement of cash flows.
Determining current cash debt coverage ratio
You can determine whether a company has enough cash to meet its short- term needs by calculating the current cash debt coverage ratio. You calculate this number by dividing the cash provided by operating activities by the average current liabilities.
Here’s the two-step formula for calculating the current cash debt coverage ratio: