Chapter 13

Making Sure the Company Has Cash to Carry On

In This Chapter

Determining a company's solvency

Gauging financial strength by looking at debt

Checking cash sufficiency

No business can operate without cash. Unfortunately, the balance sheet (see Chapter 6) and income statement (see Chapter 7) don't tell you how well a company manages its cash flow, which is critical for measuring a company's ability to stay in business. To find this important information, you need to turn to the statement of cash flows, also known as the cash flow statement, which looks at how cash flows into and out of a business through its 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 sufficient 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 aren't going to 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 it can actually put into a savings account for future use — in other words, a company's discretionary cash. This money 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, savings accounts, and other holdings that the company can easily convert to cash). The formula for calculating the free cash flow is a simple one:

• Cash provided by operating activities – Capital expenditures  – Cash dividends = Free cash flow

Cash flows from operating activities are located at the bottom of the operating activities section of the statement of cash flows. Capital expenditures appear in the investing activities section of the cash flow statement. Cash dividends paid show up 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 calculate the free cash flow in thousands:

As you can see, Mattel's free cash flow increased significantly from 2011 to 2012, by a total of about $476 million. Mattel's cash flow provided by operating activities almost doubled in that time period, from $665 million to $1,276 million.

Clearly, Mattel is recovering strongly after its bout with toxic products from China in 2007. Mattel is doing well. But if you find that a company is having trouble maintaining its previous cash levels, that issue may or may not be a sign of trouble. It may mean that the company decided to maintain lower cash levels and invest in new opportunities, or it may mean that it's having difficulty generating new cash. You can't determine that with this calculation — it tells you that the company may have a problem, but it doesn't tell you just what the problem may be. The formula merely tells you 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 management'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, in thousands:

Hasbro's free cash flow shows some improvement from 2011 to 2012, but not as significant as Mattel's. The increase from 2011 to 2012 is just $54.6 million so Hasbro has no trouble maintaining its cash flow levels — it's actually improving its cash flow.

What do the numbers mean?

Unquestionably, 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 position to weather a financial storm, whether it's 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 financing 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 most likely do not indicate a big problem. But you still want to look deeper into the financial reports, 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 caveat is especially true if you see a negative free cash flow for an older company, which immediately raises 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 specifically 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:

• $1,275,650,000 (Net cash provided by operating activities)  ÷ $6,420,881,000 (Net sales) = 19.87% (Cash return on sales)

From looking at this equation, you can see that 19.87 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 subtracting all costs and expenses), which I show you how to calculate in Chapter 11, is 12.1 percent. When you take a closer look at the inflow of cash, you can see that a significant portion of cash from operating activities was increases in accounts payable, accrued liabilities, and income taxes payable. So $312,634,000 in cash will be paid out early in 2013 to cover the bills due. That figure makes the cash position look better at the end of 2012. Even if you reduce the cash from operations by this number, Mattel still raises 15 percent of its cash from operations.

Hasbro

Using Hasbro's cash flow and income statements, I show you how to calculate the cash return on sales ratio:

• $534,796,000 (Net cash provided by operating activities) ÷ $4,088,983,000  (Net sales) = 13.08% (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 8.2 percent (see Chapter 11), which is a strong sign that Hasbro is efficiently converting 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. Mattel's results show that it's more efficient than Hasbro at turning its sales dollars into cash.

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 numbers 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:

1. Find the average current liabilities.

   • Current liabilities for current year + Current liabilities for previous  year ÷ 2 = Average current liabilities

2. Find the current cash debt coverage ratio.

   • Cash provided by operating activities ÷ Average current liabilities  = Current cash debt coverage ratio

You can find current liabilities for the current year and the previous year on the balance sheet. You can find cash provided by operating activities on the statement of cash flows.

Mattel

Using the cash provided by operating activities from Mattel's 2007 cash flow statement and the average of its current liabilities from its 2007 and 2006 balance sheets, I show you how to calculate the current cash debt coverage ratio. Using the two-step process, I first calculate the average current liabilities; then I use that number to calculate the ratio:

1. Calculate average current liabilities.

   • $1,716,012,000 (2012 current liabilities) + $960,435,000 (2011  current liabilities) ÷ 2 = $1,377,470,000 (Average current liabilities)

2. Calculate the ratio for the current reporting year.

   • $1,275,650,000 (Cash provided by operating activities, 2012)  ÷ $1,377,470,000 (Average current liabilities) = 0.93 (Current  cash debt coverage ratio)

To determine whether a company's cash provided by activities is improving, you also want to calculate the ratio for the previous reporting year. In this case:

• $664,693,000 (Cash provided by operating activities, 2011)  ÷ $1,377,470,000 (Average current liabilities) = 0.48.2 (Current  cash debt coverage ratio)

This comparison shows you that Mattel's cash position improved from the end of 2011 to the end of 2012.

Hasbro

Now I use the cash provided by operating activities from Hasbro's 2012 cash flow statement and the average of its current liabilities from its 2012 and 2011 balance sheets to show you how to calculate the current cash debt coverage ratio:

1. Calculate average current liabilities.

   • $960,435,000 (2012 current liabilities) + $942,344,000 (2011 current  liabilities) ÷ 2 = $951,390,000 (Average current liabilities)

2. Calculate the ratio for the current reporting year.

   • $534,796,000 (Cash provided by operating activities, 2012) ÷  $951,390,000 (Average current liabilities) = 0.56 (Current cash  debt coverage ratio)

For comparison's sake, calculate the ratio for the previous reporting year as well:

• $396.069.000 (Cash provided by operating activities, 2011) ÷ $951.390.000 (Average current liabilities) = 042 (Current cash debt coverage ratio)

What do the numbers mean?

The current cash debt coverage ratio looks at a company's ability to pay its short-term obligations. The higher the ratio, the better.

A negative “cash provided by operating activities” number is a possible danger sign that the company isn't generating enough cash from operations. You need to investigate why its cash from operations is insufficient. Look for explanations in the notes to the financial statements or in the management's discussion and analysis. If you don't find the answers there, call the company's investor relations department. Also look at analysis written by the financial press or independent analysts.

It's not unusual for growth companies to report negative cash from operations because they're spending money to grow the company. However, companies can't sustain a negative cash flow for long, so be sure you understand the company's long-term plans to improve its cash position.

Computing cash debt coverage ratio

You also want to look at a company's ability to pay debt that's due over the long term. Current liabilities include only debt that a company must pay in the next 12 months. Long-term liabilities are debts that a company must pay beyond that 12-month period. If you see signs that a firm may have difficulties meeting long-term debt, that, too, is a major cause for concern. Although you may find that a company generates enough cash to meet its current liabilities, if long-term debt levels are too high, the company will eventually run into trouble paying off its debt and meeting its interest obligations. You can measure a company's cash position to meet long-term debt needs by using the cash debt coverage ratio.

The formula for the cash debt coverage ratio is a two-step process:

1. Find the average total liabilities.

   • (Current year total liabilities + Previous year total liabilities) ÷ 2  = Average total liabilities

2. Find the cash debt coverage ratio.

   • Cash provided by operating activities ÷ Average total liabilities  = Cash debt coverage ratio

You can find the current- and previous-year total liabilities on the balance sheet. You can find cash provided by operating activities on the statement of cash flows.

Mattel

Using the cash provided by operating activities from Mattel's 2012 cash flow statement and the average of its total liabilities from its 2012 and 2011 balance sheets, I show you how to calculate the cash debt coverage ratio. Using the two-step process, I first calculate the average total liabilities; then I use that number to calculate the ratio:

1. Calculate average total liabilities.

   • $3,459,741,000 (2012 total liabilities) + $2,818,008,000 (2011 total  liabilities) ÷ 2 = $3,260,388,000 (Average total liabilities)

2. Find the cash debt coverage ratio.

   • $1,275,650,000 (2012 cash provided by operating activities)  ÷ $3,260,388,000 (Average total liabilities) = 0.39 (Cash debt  coverage ratio)

To judge whether a company's cash provided by activities is improving, you calculate the ratio for both the current reporting year and the previous reporting year:

• $664,693,000 (2012 cash provided by operating activities) ÷ $3,260,388,000 (Average total liabilities) = 0.20 (Cash debt coverage ratio)

This ratio serves as evidence that Mattel's cash position improved from the end of 2011 to the end of 2012. Its cash position worsened because less cash came into the company from inventories and more went out in accounts payable. Mattel's total debt increased between 2011 and 2012 by about $398.7 million, according to its balance sheet.

Hasbro

To show you how to calculate the cash debt coverage ratio, I use the cash provided by operating activities from Hasbro's 2012 cash flow statement and the average of its total liabilities from its 2012 and 2011 balance sheets:

1. Calculate average total liabilities.

   • $2,818,008,000 (2012 total liabilities) + $2,713,259,000 (2011 total  liabilities) ÷ 2 = $2,765,634,000 (Average total liabilities)

2. Calculate the cash debt coverage ratio for the current reporting year.

   • $534,796,000 (2012 cash provided by operating activities)  ÷ $2,765,634,000 (Average total liabilities) = 0.19 (Cash debt  coverage ratio)

Calculate the ratio for the previous year as well:

• $396,069,000 (2011 cash provided by operating activities) ÷ $2,765,634,000 (Average total liabilities) = 0.14 (Cash debt coverage ratio)

Taking total liabilities into consideration, Hasbro ended 2012 in a stronger cash position than in 2011, but Mattel's cash improvement was much greater. Much of that improvement, though, came from the delay in payments, as discussed earlier.

What do the numbers mean?

The cash debt coverage ratio looks at a company's ability to pay its long-term debt obligations. As you can see, when long-term debt is taken into consideration, Mattel's cash position was still better than Hasbro's, but not as strong as when looking only at current liabilities. Both Mattel and Hasbro carry a larger part of their debt as long-term debt. So calculating only one ratio — current cash debt coverage ratio or cash debt coverage ratio — doesn't give you the full picture of a company's financial health. You need to look at both ratios to be certain that the company is generating enough cash to cover both its short-term and long-term debt. In Chapter 9, I talk more about this debt structure difference when looking at the explanations given in the notes to the financial statements.

As with the current cash debt coverage ratio, if you find a negative cash from operations number, be sure to look for an explanation in the notes to the financial statements or in the management's discussion and analysis to find out why the cash flow from operations is negative. If you don't find it there, call the company's investor relations office to get the answers to your questions.

Calculating Cash Flow Coverage

Debt and the interest paid on that debt are not a company's only cash requirements. Businesses also need cash for capital expansion to grow the company (including new plants, tools, and equipment) and pay dividends to investors.

As a shareholder, you make money only when the company's stock goes up in price. The stock market rewards a company with good growth potential by bidding up the price of its stock. Firms that show low growth prospects usually have few buyers and end up with lower stock prices. So you want to invest in companies that not only generate enough cash to pay their bills, interest, and the principals on their long-term debts, but also have money left over to pay dividends to their shareholders and grow their company. Remember that many growth companies don't pay dividends at all, but instead reinvest all profits toward future growth.

You can test whether a company is generating enough cash to cover its capital expenditures, pay its dividends, and pay its debt obligations by calculating the cash flow coverage ratio.

Finding out the cash flow coverage ratio

You use a two-step process to calculate the cash flow coverage ratio:

1. Calculate the company's cash requirements.

   Add the following:

   Capital expenditures (listed in the investing activities section of the cash flow statement)

   Cash dividends paid (listed in the financing activities section of the cash flow statement)

   Interest expenses (listed on the income statement)

   Current portion of long-term debt (listed in the financing activities section of the cash flow statement)

2. Calculate the cash flow coverage ratio.

   Cash provided by operating activities ÷ Cash requirements  = Cash flow coverage ratio

You can find cash provided by operating activities on the statement of cash flows.

Mattel

I use Mattel's financial statements to show you how to calculate its cash flow coverage ratio:

1. Find Mattel's cash requirements.

   Capital expenditures	$730,950,000
   Plus cash dividends paid	$423,378,000
   Plus interest paid	$88,524,000
   Plus current portion of long-term debt	$400,000,000
   Cash requirements	$1,130,950,000

   For capital expenditures, I used two line items on the cash flow statement: Purchases of tools, dies, and molds and Purchases of other property, plant, and equipment. For current portion of long-term debt, I used the Payments of long-term debt line item on the cash flow statement.

2. Calculate the cash flow coverage ratio.

   $1,275,650,000 (2012 cash provided by operating activities)  ÷ $1,130,950,000 (Cash requirements) = 1.13 (Cash flow  coverage ratio)

Mattel generated more than enough cash from its operations to pay all its cash requirements for 2012. The 1.13 cash flow coverage ratio means that Mattel generated enough cash to cover 112 percent of its cash requirements. If a company doesn't raise enough cash from operations, it must cover the rest of the cash it needs by either borrowing money or drawing down cash on hand from activities in previous years. Any firm that must draw down savings to maintain its operating activities is likely showing signs of trouble. Anytime a company can't meet its cash requirements, you want to seriously reconsider investing in it.

Hasbro

Now I use Hasbro's financial statements to show you how to calculate its cash flow coverage ratio:

1. Find Hasbro's cash requirements.

   Capital expenditures	$112,091,000
   Plus cash dividends paid	$316,503,000
   Plus interest paid	$93,957,000
   Cash requirements	$522,551,000

   For capital expenditures, I used the Additions to property, plant, and equipment line item on the cash flow statement. Hasbro had no current long-term debt payments in 2012.

2. Calculate the cash flow coverage ratio.

   $534,796,000 (2012 cash provided by operating activities)  ÷ $522,551,000 (Cash requirements) = 1.02 (Cash flow coverage ratio)

Hasbro generated more than enough cash from its operations to pay all its cash requirements in 2012.

What do the numbers mean?

Both Mattel and Hasbro generated enough cash from operations to pay all their bills. If a company did not generate enough cash, it would have to find sources other than operations to meet the shortfall in its cash requirements.

Companies that generate more than enough cash have a cash flow coverage ratio of more than 100 percent. The higher the ratio, the better. If you see a company that isn't able to cover its cash requirements and that has little left in cash and short-term investments, raise that red flag.