Beyond ROE: Return on Net Operating Assets (RNOA)

Many investors rely on Return-on-Equity (ROE) to gauge a firm's ability to generate profit from each dollar of equity; a somewhat fundamental determination when assessing the attractiveness of owning a piece of that equity. The problem is, ROE is calculated as net income divided by average stockholders equity, meaning that you have no idea the extent to which leverage played a role in the returns generated for shareholders. In the aftermath of the credit bubble, it should be apparent that not all returns are created equally. For instance, had you been an investor in Merrill Lynch around say, 2006, you may have been lulled into complacency by the firms ridiculous returns-on-equity; oblivious unfortunately to the fact that MER's performance was merely the result of massive amounts of leverage. Fortunately, through calculation of a firm's Return on Net Operating Assets (RNOA), we can isolate the portion of ROE attributable to the operations of the business (the portion that matters).

The general concept behind RNOA is that ROE= Operating Return + Nonoperating Return. As I've said, investors should focus on the operating portion of return, which is calculated as follows:
Operating Return (RNOA) = Net Operating Profit After Taxes (NOPAT) / Average Net Operating Assets (NOA)

The calculation of RNOA requires you be able to differentiate between the operating, and nonoperating items on both the balance sheet and income statement. This should be somewhat easier to do with the income statement, just because although GAAP doesn't require it, most companies will break out their operating results on their financial statements. Management tends to be judged based on the firms operating results, so this shouldn't be surprising. I'll refer to Dell's most recent full year results to illustrate the RNOA calculation.

Step 1: Calculate NOPAT
For FY '09, Dell logged pretax income of $3324M, and income tax expense of $846M, resulting in an effective tax rate of 25.45% (846/3324). Dell posted operating income of $3190M; therefore, applying the 25.45% tax rate, we can state that Dell's NOPAT is $2378M ($3190 X (1-.2545) ). 

Step 2: Calculate average net operating assets (NOA)
First of all, Net Operating Assets =  Operating Assets - Operating Liabilities. The components of each category are listed below.
Operating Assets
Cash/Cash Equivalents
Accounts Receivable
Inventories
Prepaid expenses
Other Current Assets
Property, plant and equipment (net)
Capitalized lease assets
Natural Resources
Equity method investments (unless unrelated to the core business)
Goodwill and other intangible assets
Deferred income tax assets (current and long term portions)

Other long term assets

Operating Liabilities
Accounts Payable
Accrued Liabilities
Deferred income tax liabilities (current and long term portions)

Pension and other post-employment obligations

Dell's 2009 and 2008 NOA are $6488M and $7501M, respectively. The average of these two numbers is $6995M. Therefore:


RNOA = NOPAT / NOA
= $2378 / $6995
=34%


This compares with a 2009 ROE of:
ROE= Net Income / Avg Stockholders Equity
= $2478M / $4003M
=61.9%


A conclusion which can be drawn from these results is that only 55% of Dell's ROE (34/61.9) is attributable to operations. I'd generally like to see a higher ratio of operating to nonoperating return; however, Dell's 34% RNOA is substantially higher than the 10% average RNOA for publicly traded companies. A further examination into Dell reveals that it's debt-to-equity ratio (total liabilities divided by total stockholders equity) is 5.2, meaning that for every dollar of equity, dell has $5.20 worth of debt. This high debt to equity ratio partially explains the juiced ROE number, and should probably be monitored by investors.


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Vertical Analysis of Financial Statements: Coca-Cola v Pepsi

Due to the complexity of corporate financial statements, the prospect of deciphering meaningful insight can be a daunting task. Furthermore, the ratios deployed by professional analysts are numerous, effectively creating a thousand piece jigsaw puzzle whose composition perpetually and frequently fluctuates. Luckily, for those of you who lack either the time or mental stamina to perform calculations such as the disaggregation of the components of return on net operating assets (RNOA), a relatively effective process exists known as Vertical Analysis. The premise of Vertical Analysis is to create common-size financial statements, where all balance sheet and income statement items are converted into percentage terms for purposes of comparison.Using vertical analysis, comparisons can be made between firms regardless of size. This approach is especially useful when determining the relative financial health of competing firms within the same industry. Financial metrics display a large degree of variability across industries; however, within a given industry, competitors should be fairly aligned in terms of funding sources (debt v equity), liquidity, asset turnovers etc. Below is a vertical analysis I prepared using the FY '08 balance sheets from Pepsico (PEP) and Coca-Cola (KO).
Vertical Analysis of Financial Statements - Pepsi v Coke

From here, it's fairly easy to scan through Coke and Pepsi's relative balance sheet percentages(page 2 of pdf) , making some fairly useful generalizations. The first thing I noticed from this comparison is that Pepsi and Coca-Cola have a nearly identical composition of current v long term assets (30/70). However, Cash/Cash Equivalents represents 11.7% of Coke's assets, but only 5.7% of Pepsi's. It appears that Pepsi makes up the difference in it's proportion of (net) receivables to assets (13% v 7.6%); this could just be a timing issue, but it could also mean that Pepsi has become more aggressive in terms of the conditions by which it will offer credit to customers. The next observation I'd make has to do with differences between the two company's capital structures. Pepsi's debt/equity split percentage is 66.2/33.8, whereas Coca-Cola's capital structure is comprised of 49.5% debt and 50.5% equity. Interestingly though, Pepsi's short term debt only represents 1% of the right side of the balance sheet, whereas Coca-Cola comes in at 16.1%. This could just be an indication that Coke relies more heavily on commercial paper to fund it's short term operations; it could also mean that Coke has a significant amount of long term debt coming due in the months ahead. Coca-Cola's 2008 10-K should contain footnote disclosures describing the nature of these short term obligations. In this sense, the vertical analysis above serves as an informative starting point from which to diagnose any potential issues the firm might have down the road. Additionally, vertical analysis can expedite the analysis process by narrowing down which footnotes you, as an investor, should be concerned with.

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Fed Flushes $1.7B Worth of Taxpayer Funds Down the Toilet

Last week, under the cover of darkness and in an extraordinary show of Government incompetence, the FDIC seized United Commercial Bank. The problem is that Mingsheng, a Chinese bank, had already approached the Fed about a potential acquisition of UCB. Mingsheng, which had already invested $129M into UCB, was presumably trying to salvage some portion of it's investment. Unfortunately, Mingsheng's application was destined to whither away on a bureaucrats desk, as various branches of the federal government bumbled about in an attempt to resolve the problems at UCB - oblivious it seems to the cost effective solution right before their eyes. They (Mingsheng) were not the only investors though; last year the Treasury injected $298M into UCB as part of the now infamous TARP program. Furthermore, the FDIC estimates that the UCB failure will cost it's Deposit Insurance Fund $1.4B. The DCF is theoretically funded through premia leveled on the banking industry; however, we all know that this cost gets passed onto consumers in the form of higher overdraft, ATM, inactivity etc. fees. Therefore, the Treasury/Fed/FDIC - acting in disorganized concert - managed to flush $1.7B worth of taxpayer money down the toilet.

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Diluted EPS and the Capital Structure

Although the financial media's reporting centers almost entirely on a corporation's reported basic earnings-per-share (EPS), most analysts have historically paid attention to a different line on the income statement: Diluted Earnings per Share. Diluted EPS takes into account the potential dilutive effect that would ensue if holders of the firms preferred stock and bonds were to convert their stake into common equity. This possibility theoretically exists whenever investors purchases securities that include a conversion option. Usually there is some sort of market based trigger point, but ultimately those details will be contained on the face of the preferred stock certificate, or in the bond covenants. For the sake of simplicity, let's say that Company X earned $1000 in a given quarter, and there are 1000 shares outstanding, resulting in quarterly Basic EPS of $1/share. However, let's assume that Company X has also financed itself via 500 shares of convertible preferred stock which give holders the right to convert each preferred share into 2 shares of common equity. Assuming that all preferred holders exercised that option, Company X would record 2000 outstanding shares of common stock, and would only have earned 50 cents/share for the same quarter. This hypothetical example is rather extreme for the purposes of making a point; below is a chart showing Basic v Diluted EPS during the most recently reported quarter for 7 large firms:
Corporations must disclose both basic and diluted EPS on the income statement, however the actual calculation is below for those who must know:

Diluted EPS = (Net Income - Preferred Dividends) / (Weighted Average # of Common Shares Outstanding + Additional Shares Due to Dilutive Securities)

Arithmetically, we can see that the dilutive effect increases the denominator, reducing the amount of net income available to each shareholder. In many firms with simple capital structures, the basic and diluted EPS numbers will be identical. However, firms that utilize more complex financing instruments generally have more potential for dilutive equity conversions.

Going forward, I would expect Diluted EPS to continue to gain significance, especially with regards to analysis of financial corporations. As banks struggle to refinance trillions of dollars worth of debt, the use of convertible options should become more popular for a couple of reasons. First, a conversion option represents value to the investor and additional capital for the borrower. Second, if the conversion option is tied to a regulatory trigger like TCE ratios, then the borrower is essentially selling an automatic equity boosting instrument for times of market distress. If things play out like I anticipate regarding convertible debt, the gap between basic and diluted EPS will grow further. Equity investors need to monitor these developments to insure that they are not diluted into oblivion.

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Contingent Convertible Bond Ruminations

The latest idea to revolve around the task of inoculating the global financial system involves a financial instrument known as the contingent convertible bond. Overall, I'm somewhat pleased that the discussions surrounding financial reform have begun to deviate from the bonus-recipient-witch hunt mentality which has dominated the Obama Administration's rhetoric to date. Furthermore, it's encouraging to see the private sector begin to formulate it's own prescriptions; opposed to of course government solutions which amount to nothing more than throwing (other people's) cash at the situation, appointing czars of every shape and form, and hoping the problem solves itself.

Contingent convertibles are a nifty bit of financial innovation (isn't that supposed to be synonymous with evil and destructive?) that takes regular convertible bonds and adds a twist. The process would play out something like this:

1. Investors give cash to banks, and in return, they receive contingent convertible bonds.
2. Investors receive regular coupon payments, just like with any other bond.
3. If and only if the bank's capital ratio falls below a certain threshold determined by the bond contract, the instrument will convert into equity.

Part of the draw for contingent convertibles is that the conversion clause is not based upon observable market prices. In that sense, even the most concerted efforts by short-sellers can not trigger the conversion. Conceptually, assuming these instruments comprised a significant enough portion of global banks' capital structures, they would act as automatic stabilizers during periods of economic distress, bolstering banks' capital ratios without the need for TARP-like government interventions. As an aside, will widespread use of contingent convertibles be evidence of the Europeanization of financial markets? We all know how much the Europeans love their automatic stabilizers.

To briefly play devil's advocate, I could see the establishment of contingent convertibles causing a wholesale shift in the way bank stocks are valued. Capital ratios would be monitored very closely in order to develop a probability of equity conversion; this could cause bank stocks to prematurely fall in anticipation of a massive equity dilution. I could also see bank stocks' losing all of their appeal in terms of a dividend investment. That might not be an issue now, what with 1 cent dividends imposed by the Treasury; however, I have to assume that by say 2015, banks will once again be paying healthy dividends. The problem is from the banks standpoint, the debt to equity conversion will amount to the elimination of a contractual obligation to make semi-annual interest payments, and replace it with the extremely optional payment of a dividend. If I were investing in a bank's contingent convertibles from a current income perspective, I would prefer that the potential conversion be structured so that I received some class of preferential stock whereby a dividend comparable to the coupon rate was guaranteed. Nevertheless, the discussions surrounding contingent convertibles is a net positive in my book; we'll just have to wait and see if this new "movement" has the legs necessary to become a widespread reality.
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Analyzing Leases On and Off the Balance Sheet

In the midst of the criticism that's been leveled towards financial innovation of all shapes and sizes, one form of financial instrument in particular has managed to travel under the radar: leases. Although leases have never been accused of wreaking financial destruction, they do serve as a convenient means of off-balance sheet financing.

The first thing to know about leases as they pertain to financial statements is that there are two main categories: Operating Leases and Capital Leases. The closer a lease is to an actual purchase agreement, the more likely it is that the lease should be classified as Capital. There are however four conditions which, if any are met, automatically render the agreement a Capital Lease. They are:

1. The lease agreement contains a provision whereby, at the end of the lease term, title to the leased asset is transferred from the lessor to the lessee.
2. The lease agreement provides the lessee an option to purchase the leased asset at bargain terms (like $1 for instance)
3. The term of the lease agreement constitutes a period of time which is greater than or equal to 75% of the leased assets useful/economic life.
4. The present value of all scheduled lease payments is greater than or equal to 90% of the fair market value of the leased asset.

At this point, you're probably questioning why it really matters whether accountants refer to the lease as Operating or Capital. Simply put, a Capital Lease must come onto the balance sheet via a debit to Leased Asset and a credit to Lease Liability. The amount recorded on the balance sheet is the present value of all future lease payments. Operating Leases on the other hand are not capitalized, and only appear to external stakeholders in the form of footnote disclosures in regulatory filings. The accounting for Operating Leases is relatively straightforward however; lease payments simply flow to the income statement and are recorded as Rent Expense. Capital Leases though, have interest and principle components that must be amortized over the lease term just like a debt instrument. Below is an amortization schedule for an asset of FMV $70,000 , a lease term of 6 years and $15,000 annual payments. Using the Internal Rate of Return (IRR) function on Excel, I'm able to discover that the lease contains an implied interest rate of 7.69%.
As I mentioned above, the leased asset must be depreciated over time. Below is the depreciation table for the same example.
The table above brings me to the next point: expenses under a Capital Lease are front-loaded, whereas an Operating Lease maintains consistency. In years 1-6 in the above example, the total expense for an Operating Lease would be $15,000/year. Keep in mind that my prior point isn't applicable to the cash flow statement; I'm only discussing income statement implications. From a cash flow standpoint, the interest portion of Capital Leases is classified as a Financing Activity, and the principal re-payment is considered an Operating Activity. Under Operating Leases, the entire rent expense is classified as an Operating Activity. In this sense, Capital Leases will result in higher cash flow from operations than a similar Operating Lease.

The final nuance that's important to grasp is that Operating Leases can distort certain leverage related financial ratios such as debt to equity and return on assets (ROA). The distorting effect can range from very minimal to materially drastic, especially in the case of businesses like airlines who lease the majority of their assets. Nevertheless, leases should be reason alone to spend some time examining the footnote disclosures found in your subject firm's financial statements.

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Corporate Inventory Analysis and Costing Methods

For Home Depot (HD) and many other corporations, inventory represents one of the single largest items on the balance sheet. For 2008, inventory represented 25.9% of Home Depot's total assets. Furthermore, inventory turns over many times throughout the course of the year, feeding into the firm's income statement through cost of goods sold (COGS). In order to understand inventories, you first need to be aware of the three major inventory costing methods.

When the concept of inventory costing methods was first presented to me, I wasn't sure what exactly there was to talk about; if a company buys a widget for cost X, it would make sense that upon the sale of that widget, X dollars would flow to cost of goods sold. Furthermore, if you had to place a value on your inventory in it's entirety, it would make the most sense to simply report the sum of the cost of all items in inventory. Unfortunately, the accountant powers- that- be didn't design inventory costing in such a straightforward manner. As a corporation, you basically have three choices in terms of inventory costing: first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. In FIFO, the oldest price stored in inventory is assigned to cost of goods sold. With FIFO, the most recently recorded price is attached to the good and flows to COGS. Average cost, as the name implies, assigns the average cost of the inventory item. During inflationary times, the FIFO costing method is the most profit-advantageous because yesterday's cost is being booked as today's expense. The opposite would of course apply during times of falling prices. Because of the profit implications, the IRS requires corporations to remain consistent with their costing method. From what I've been told, the IRS will allow you to switch methods - but only once. Below is a quick example showing how different inventory costing methods can result in completely different COGS (and subsequently gross profit margins) - for the same transaction.
In this simplified example, I'm assuming that Company A is purchasing hammers from the manufacturer/distributor, holding them in inventory, and subsequently selling them at its retail locations. I'm also assuming some severe inflation in the hammer supply industry, but it was done to help clarify the point. As is evident though, FIFO leads to significantly lower cost of goods sold, gross profit margins, and ultimately net income. You should check the footnotes that accompany the firm's financial statements to determine which method is being used. This is important due to a profit-boosting phenomenon known as LIFO Liquidations, which usually occurs during times like now when corporations are allowing their inventories to dwindle lower and lower without replacement. The result is that new sales begin to cut through years of (assumedly lower) price layers, lowering COGS and boosting net income. This could result in a temporary profit windfall, however it's unlikely to repeat itself, and should almost be considered an extraordinary aspect of income (in my humble opinion).

Now that you have a cursory grasp of inventory costing, I'll move on to two ratios that will help to assess a given company's inventory situation: Inventory Turnover and Average Inventory Days Outstanding.

Inventory Turnover measures the number of times that a firm's inventory has "turned over" during the year. It's calculated as follows:

Inventory Turnover = Cost of Goods Sold / ( (Starting Inventory + Ending Inventory) / 2 )
Home Depot's Inventory Turnover
= $47,298M / ( ( $10,673M + $11,731M) / 2 )
= $47,298M / ($22,404M / 2)
= $47,298M / $11,202M
= 4.22

The implication here is that Home Depot's inventory turned over 4.22 times during its 2008 fiscal year.

Some sources provide a several step process for determining the next ratio, Average Inventory Days Outstanding. The shortcut though is to just 365 and divide it by Inventory Turnover. For Home Depot:

Average Inventory Days Outstanding = 365 / (Inventory Turnover)
=365 / 4.22
=86.49

This means that, during 2008, the average item spent 86.49 days in Home Depot's inventory. This ratio should be compared across several years to determine trends in the firm's inventory. As an example, during 2007, Home Depot's average inventory days outstanding was 87.25. This means that Home Depot actually improved its turnover from 2007 to 2008, which is contrary to what I would expect during a recession. This year-over-year comparison is probably most indicative of efficient inventory controls at the company. My expectation though is that when Home Depot reports fiscal 2009 results (towards the beginning of February 2010) we'll be able to observe an increase in the average inventory days outstanding. I may be wrong though, and HD could have conceivably scaled down its inventory to meet sales demand in an efficient manner that will allow it to remain consistent with its ~86 day turnover rate. It's items like these that should allow investors to discern between market leaders and laggards coming out of this recession (and into the new normal?)

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Liquidity Analysis Part 2: Current Ratio and Quick Ratio

In the first installment of my liquidity analysis discussion, I covered Net Working Capital; which is defined as Current Assets minus Current Liabilities. There are two additional ratios that should be a part of investor's liquidity analysis: the current ratio and the quick ratio. Both the current and the quick ratio are calculated entirely from the "current" section of the balance sheet. To refresh, current assets are cash, short term investments, receivables, inventory, or any other asset that the company expects will be converted to cash within a year or less. Current liabilities are accounts payable, expenses that accrue on a regular basis like wages, short term notes, and the portion of long term debt due within a year or less. The "due in one year or less" is a consistent theme which applies to current liabilites. To illustrate this distinction, I've included Intel Corporation's (INTC) consolidated balance sheet (2006-8) below:
Although not entirely scientific, I like to think of current assets and current liabilities as the corporation's revolving door; these portions of the balance sheet are turning over constantly between reporting periods. In contrast, non-current assets like buildings and machinery are relatively immutable, as are the portions of debt which mature many years down the road. In that sense, a corporation could own every parcel of land on the east coast, but without the liquidity contained in current assets, might conceivably be unable to pay it's bills or service it's debt. The previous example, although extreme, underscores the importance of applying both of the following ratios during your analysis of financial statements.

Current Ratio
The Current Ratio is simply current assets divided by current liabilities. The point is basically to measure how many times the firm's current assets can cover it's current liabilities. I'll use the figures from Intel's 2008 balance sheet to calculate it's current ratio.

Intel's Current Ratio = Current Assets / Current Liabilities
= $19,871M / $7818M
= 2.54

Generally, a current ratio above 1 is indicative of a strong current liquidity position. At 2.54, Intel appears to have more than sufficient liquidity necessary to cover it's payables and other short term debts coming due within the year.

Quick Ratio
I think of the quick ratio as a more precise glimpse into the firm's liquidity position. It basically measures whether the corporation could, if needed, quickly pay down all of it's current liabilities. The calculation here is Cash/Cash Equivalents divided by Current Liabilities. Below is a calculation of Intel's quick ratio for 2008:

Intel's Quick Ratio = Cash and Cash Equivalents / Current Liabilities
= $6512M / $7818M
= 0.83

To verbalize Intel's quick ratio, I'd say that Intel has 83% of the cash necessary to fund it's current liabilities. This is actually a relatively healthy quick ratio, and isn't expected to be greater than 1. Furthermore, if you look at the rest of Intel's current assets, you'll see $5331M worth of Short Term Investments. As Intel cashes out these investments over the subsequent twelve months, it will have substantially more cash than necessary to meet it's short term liquidity needs.

*Note: many analysts will include marketable securities and accounts receivable in the numerator of the quick ratio, the theory being that these items could be liquidated quickly. You may want to look at both calculations; however, I don't like assuming that a company can just go out and factor it's receivables on the market without taking a substantial hit.

As usual, it's important to monitor how these ratios change over time, as it will illustrate whether the firm is becoming more - or less - liquid with the passage of time. In the current environment, it should be obvious which way you'd like to see these measures trending.

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Liquidity Analysis Part 1: Net Working Capital

The term liquidity can be interpreted in various ways, depending of course upon the specific circumstances. In corporate financial accounting, liquidity refers to the firm's ability to pay its debts when they are due. The importance of possessing that ability should be self evident, as should the ability to evaluate a firm's liquidity position.

The first measure that you should be able to calculate is Net Working Capital:

Net Working Capital = Current Assets - Current Liabilities
Intel's 2008 Net Working Capital = $19,871M - $7818M
= $12,053M

In order to properly grasp the concept of Net Working Capital, you should be familiar with the two balance sheet accounts used to calculate it; Current Assets and Current Liabilities. Current Assets are basically those assets which are not necessarily long term in nature. It includes cash and cash equivalents, accounts receivable, and inventory held by the firm for sale. You should know however, that items like prepaid rent and prepaid insurance for the next 12 months also fall under Current Assets. Current Liabilities are short term notes payable, accounts payable, and the portion of long term debt that is due within the year. That being said, it should be evident that the prepaid rent portion of Current Assets wouldn't satisfy the cash obligation portions of Current Liabilities. The point is, investors need to dig in a little bit to determine the actual quality of a firm's net working capital. Also, it can be instructive to compare a firm's changes in net working capital over time. The chart below serves that purpose for Intel Corporation (INTC):
From the chart above, I'm not sure whether any discernible trend can be declared. Most likely, Intel was making use of it's cash for investments/acquisitions from 2003-2006, thus lowering it's net working capital. Intel is not a highly leveraged corporation - relatively speaking - though, so I wouldn't be too concerned with these fluctuations. If however, we observed that net working capital was declining, and over the same period the firm's debt-to-equity ratio was rising, it might be wise to pause and examine just why this was occurring.

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Depreciation and Financial Statements

The formal definition of depreciation is the systematic allocation of the cost of an asset, as an expense, over a period of time. If I were able to provide a definition for depreciation, it would be " a non-cash expense on the income statement, recorded in order to display the theoretical consumption of an asset's useful life". Before I get started, it's important to understand the distinction between depreciation recorded on a firm's financial statements, and the depreciation expense used by a corporation to determine it's federal income tax liability. Basically, there are two separate books that can show different depreciation expense for the same asset, in the same year. The depreciation schedule that a corporation must follow on it's tax returns is known as the Modified Accelerated Cost Recovery System (MACRS). If you want to read about MACRS, you can refer to IRS Publication 946; I will be covering depreciation strictly from the financial statement standpoint.

The two concepts you need to initially understand about depreciation are "Useful Life" and "Residual Value". An asset's useful life is the period of time that the asset will provide an actual economic benefit to the company; although an excavator could in theory still be alive after 50 years, the company might know from experience that an average excavator can only usefully serve its purpose for 15 years; therefore, useful life = 15 years. Residual value is also called salvage value, and its basically an estimate of what the asset could be sold for (as scrap usually) after it has served the duration of it's useful life.

There are basically three accepted depreciation methods that corporations use to convey information on financial statements: straight line, double declining balance, and units of production. To determine the annual depreciation expense for an asset using the straight line method, you simply plug your numbers into the following formula:
Annual Depreciation Expense = (Cost of Asset - Residual Value) / Useful Life.
Let's say a corporation purchases a truck for $110,000, estimates a $10,000 residual value and 10 years worth of useful life for the truck. A depreciable base of $100,000 (cost-residual value), divided by 10 years (useful life) yields an annual depreciation expense of $10,000. Unless the firm ever determines that the truck's useful life or residual value has changed materially, this $10,000/year will remain constant for each of the subsequent 10 years.

To determine the annual depreciation expense under the double declining balance method, you first need to determine the annual rate of depreciation by plugging your information into the following formula:

Rate of Annual Depreciation = (100% / Useful Life) X 2
Using the same truck example from above, we'd calculate (100% / 10 years) X 2 = 20%. Step 2 involves plugging your depreciation rate into the following formula:
Year 1 Depreciation Expense = (Cost of Asset - Residual Value) X Annual Depreciation Rate
= ($110,000 - $10,000) X 20%
=$20,000
That $20,000 shows up as depreciation expense in Year 1 on the income statement, and also appears in a contra asset account on the balance sheet known as "Accumulated Depreciation". The calculation for depreciation expense in Year 2 is as follows:
Year 2 Depreciation Expense = (Cost of Asset - Accumulated Depreciation - Residual Value) X Depreciation Rate
=($110,000 - $20,000 - $10,000) X 20%
=$16,000
Once again, $16,000 flows to the income statement as an expense, and is added to Accumulated Depreciation, resulting in a new balance of $36,000 at the end of Year 2. What should be evident is that the double declining balance method results in a front-loading of an asset's depreciation towards the beginning of it's useful life. By the end of the asset's useful life however - in this case Year 10, both methods will have all of the asset's value except for the residual value.

The units of production methods is, in my opinion at least, the most effective/honest/straightforward method of depreciation. Unfortunately, it only works when the asset has a useful life that can be represented in terms of a unit of measurement. For instance, using the truck example again, let's say that the company estimates the truck will provide 200,000 miles worth of service. Operating off an identical depreciable base of $100,000, the company could state that each mile amounts to 50 cents worth of depreciation for the truck. Thus, if the trucks trip log showed 50,000 miles of service for the year, the formula for annual depreciation using the units of production method is as follows:
Annual Depreciation Expense = ( Units of Useful Life / (Asset Cost - Residual) ) X Units consumed
= ( 200,000 / ($110,000 - $10,000) ) X 50,000
= $25,000

The only other depreciation caveat to be aware of at this point is that sometimes management adjusts it's estimates regarding the asset's useful life and salvage value. Luckily, these estimate changes are applied to the depreciation schedule prospectively; that is, you simply readjust the schedule for the new variables based upon the already accumulated depreciation and original cost.

Practically speaking, you can use your knowledge of the accumulated depreciation balance sheet account to gauge the relative age of the firm's long term operating assets. Simply divide Accumulated Depreciation by the amount of long term assets to determine a depreciation percentage. If your answer is in the 10-20% range, the firms assets are relatively new, and so on. Older assets on the balance sheet could be a sign that the company will have to ramp up it's capital expenditures in the coming years.

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Bond Pricing 101

If you're going to learn how to effectively interpret corporate financial statements, it's a good idea to possess at least a cursory understanding of the pricing of long-term non-operating liabilities - also known as bonds.

To start off, you need to know that bond pricing involves two separate interest rates, the Coupon Rate and the Market Rate. The coupon rate, also known as the contract or stated rate, is the interest rate listed in the bond contract, and is used to compute the amount of the cash interest payments that are due periodically from the issuer. The market rate is the interest rate demanded by investors, and is usually referred to as the bond's "yield".

Next, you need to think of a bond in terms of the two distinct cash flows involved; the bond pays periodic, usually semiannual interest payments (interest annuity), as well as the lump sum principal amount (face value) which is returned at maturity.

Moving on, the next distinction which needs to be made is that the price of the bond varies depending upon the relationship between the coupon and the yield. If the two are the same, the bond is priced at what is known as "par". If the market rate is greater than the coupon rate, the bond will be priced at a discount; conversely, if the coupon rate exceeds the market rate, the bond is priced at a premium. I'll start with pricing a bond at par; it's a much simpler process, for reasons I'll touch on a bit later. The assumptions used in this example of pricing a bond at face value are as follows: Face amount of $800,000, annual coupon rate of 6%, semi-annual interest payments, and a 5 year maturity. The first step involves calculating the interest payment, the formula for which is:
Interest Payment = Face Value X Annual Coupon Rate X Payment Period (time)
= $800,000 X 6% X 6/12
= $24,000
Next you need to calculate the present value of both sets of cash flows. Instead of going into detail on the present value calculation, I'll just direct you to the PV() function in Excel. Present value is built on the concept that $24,000 today is worth less to the investor than $24,000 in three years, simply due to the time value of money. In the current example, it's easy to ascertain that the sum of the bonds interest payments over the five year period is $240,000 ($24,000 X 5 (years) X 2 (payments per year). However, the present value of those five years worth of payments is only $204,724.87. Along those same lines, the present value of (the lump sum principal payment of) $800,000 is only $595,275.13. Now, we sum the present value of the bonds future cash flows:

Present Value of Cash Flows = $595,275.13 + $204,724.87 = $800,000

Well then, this all looks pretty simple: the present value of a par priced bond's future cash flows is in fact the face value of the bond. For bonds sold at a premium or a discount however, the equation shakes up a little differently. For a discount example, let's assume that all of the variables are identical to the par example above, except that the market is demanding an 8% yield. The calculation of the cash interest payment still uses the coupon rate, so we arrive at an identical $24,000 semi-annual interest obligation for the issuer. The curve ball arrives when calculating the present value of the bond's future cash flows; these cash flows must be discounted using the bond's yield rate of 8%. Therefore, the present value of the discount bond's interest payments is $194,661.50, and the principal payment's present value is $540,451.34. Add them together, and you arrive at $735,112.83. What this means is that the bond issuer will receive $735,112.83 in cash from investors, but will still be required to make $24,000 interest payments (that were calculated using a face value of $800,000). The difference of $64,887.17 (discount balance) shows up on the balance sheet as a contra-liability account which reduces bonds payable in line with the amount of cash actually received by the issuer. The discount balance is then amortized over the life of the bond, and falls into the income statement as successively higher amounts of interest expense (although not an actual cash outlay). The amortization table for this example is below:

As you can see above, the bond discount amount feeds - in entirety - into the income statement throughout the 10 periods, until it is no more. A bond sold at a premium works in the exact inverse way; a premium balance is created on the balance sheet which effectively reduces the issuer's interest expense - by the premium amount - over the life of the bond. Obviously, the issuer would prefer to sell bonds at a premium. Despite the interest expense reduction, a premium usually means that the market judges the firm to be more credit worthy than implied by the coupon rate. Nevertheless, it's important to comb through a corporation's filings to determine the amounts and associated maturities of it's bond liabilities, and be able to understand the income statement ramifications.



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Times Interest Earned and Credit Risk Analysis

When determining an individual's qualifications for taking out a mortgage of a certain amount, the ideal situation involves the bank/mortgage broker/real estate agent calculating a simple ratio based upon payments/obligations to income. Where p=mortgage payment, r=other recurring payments, and i=gross monthly income, the ideal situation dictates that (p+r)/i should be less than or equal to 36%. A corporation's creditworthiness is inherently a more complex determination, although today's concept is - from a logical standpoint - similar in nature to the mortgage brokers "back of the napkin" recurring obligations to income ratio.

Times Interest Earned (TIE) is essentially a measure of how many times a firm's interest expense is covered by it's earnings before interest and taxes (EBIT). Depending upon whether the company specifically reports EBIT in it's income statement, you may have to do some simple math to arrive at the ratio's correct numerator. For instance, you may only be provided with the firm's pretax earnings; in this case, just add interest expense in order to arrive at the EBIT figure. Below is the formula, along with Hewlett-Packard's calculation as an example:

Times Interest Earned (TIE)= Earnings Before Interest & Taxes / Interest Expense

Hewlett-Packard's TIE = EBIT / Interest Expense
= $10,940M / $467M
= 23.43

This rather impressive example means that, for FY 2008, Hewlett-Packard earned 23.43 times it's interest expense before taxes. That number is not so high for many other firms, as can be seen in the chart below:

As usual, it's most instructive to compare these figures across industries, and over time. Below is a graph showing Comcast Corporation's (CMCSA) TIE calculation for FY's 2004-2008:
In general, we can say that the latter part of this decade has been good for Comcast, as it's TIE ratio increased from 2X to 2.5X. If the company was incurring additional long term debt during the time period of 2004-2008, we can assume that these were prudent borrowings which allowed Comcast to grow earnings at a greater rate than it's increase in debt service. A five year TIE chart, similar to the one above, should be a part of any investors credit risk analysis.

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Intro to Credit Risk Analysis: Debt-to-Equity Ratio

If recent financial market events have taught us anything, it's that a) leverage can work both ways, and b) when leverage works against an individual/corporation/investment entity, the results can be fairly disastrous. Although the pair of statements above are essentially commonly held knowledge, the behavior exhibited by market participants throughout the past 20 years was nothing if not a blatant disregard for this reality. Moving forward, it will be more prudent than ever for investors to perform a sober assessment of a corporation's use of leverage.

At the heart of credit risk analysis is a corporation's solvency, or in other words, it's ability to function as a going concern, capable of avoiding financial distress. The cornerstone of evaluating solvency is the Debt-to-Equity Ratio, which as the name implies, looks at a firms absolute debt level in terms of a multiple of total stockholders' equity. Both parts of the equation can be found on the balance sheet, and are plugged in as follows:

Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity

Verizon's (VZ) Debt-to-Equity Ratio is calculated as follows:
Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity
= $160,646M / $41,706M
= 3.85

In other words, for every dollar of Shareholders' Equity, Verizon holds $3.85 worth of debt. This ratio will obviously fluctuate greatly based upon the industry, and the composition of the firm's funding sources, i.e. relative breakdown of debt v equity funding. The chart below compares Verizon with seven other large firms from a debt-to-equity ratio standpoint:
Clearly, the debt-to-equity ratio needs to be examined from within the context of the individual firm and industry as a whole. For instance, there are two reasons why I wouldn't be alarmed at Verizon's high ratio of debt funding. First, it's subscriber based business provides relatively stable and predictable cash flows; a distinction that translates into ample access to the bond market. Secondly, a major portion of Verizon's borrowing activity over the past couple of years has been geared towards investment in it;s FiOs network. I haven't assessed that product from a consumer standpoint, but feel certain that Verizon will be able to leverage it's market leadership position into a substantial FiOs subscriber base.

Step 2 in the credit risk analysis process is determining the firms ability to cover interest payments from internally generated cash. That ratio will be addressed in a future article.

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