Basic Principles of Revenue Recognition

Common sense would indicate to most people that the issue of revenue recognition shouldn't even be an issue; after all, a sale has either occurred or it hasn't right? The problem is, due to the multitude and variety of transactions that occur in the modern economy, it isn't always clear when a firm may record a given sales dollar. For instance, when several pieces of software are sold in a bundle, and a right of return exists for any of the individual bundled components, then at what point can the company reasonable assert that the sale is final? To look for guidance on this issue, we have to consult with dual sets of regulatory guidance, originating from the FASB and SEC.

The FASB guidelines for revenue recognition involve two primary criteria, both of which must be met in order for the sale to be legitimate and reportable as revenue:

1. The revenue must be realized or realizable
2. The revenue must be earned; that is, the company has performed it's duties under the terms of the sales agreement.

The general picture here is that the FASB has developed a relatively straightforward, common sense set of criteria for assessing when a sale...is a sale. The company must both have the cash - or be reasonably sure that it can collect the cash - and has actually delivered its product or service. The guidance doesn't stop there though; the SEC, via Staff Accounting Bulletin (SAB) 101, has issued four additional pieces of guidance in clarification of the principles of revenue recognition: 

1. Persuasive evidence that a sales agreement/arrangement exists must be present. The SEC appears to believe that this principle is very important in relation to arrangements that customarily require a written sales agreement between the buyer and seller, specifically as it relates to the timing of product delivery and execution of a sales agreement. If product delivery and sales agreement execution fall in different fiscal periods, revenue can only be recognized in the later accounting period (during which both have been completed).
2. Delivery has occurred or services have been rendered. The SEC seems to be interested in the passage of title and assumption of risks associated with the delivered product. A consignment store may have received delivery of a product, but it hasn't assumed title, or any of the risk associated with owning the product. As such, revenue can not be recognized until the consignment product has been paid for.
3. The seller's price to the buyer is fixed or determinable. The SEC's primary focus with regards to this rule has to do with "side agreements" that may have attached themselves to the primary sales arrangement. Sometimes, the practical effect of these side agreements is to transform a sale into a demonstration period or otherwise incomplete sale. In such cases, the associated revenues may not be recognized. The SEC further explains that when the right of return is structured so that the dollar value of returnable product declines according to a fixed schedule over time, the associated revenue must be recognized according to that schedule.
4. Collectibility is reasonably assured. This requirement is not explicitly addressed in SAB 101, however the general principles outlined in the bulletin can be applied towards its understanding. If the transaction is customary, historic data indicates a reasonable expectation of collectibility, and no external factors which might affect the transaction have significantly changed, then we can probably infer that the requirement has been satisfied. There are some obvious factors that could hinder the assurance of collectibility, such as bankruptcy proceedings or major litigation.

Because the SEC has issued these guidelines, they must be followed in addition to the FASB/GAAP requirements. As business practices evolve, its likely that the issue of revenue recognition will continue to be clarified and revised accordingly. Nevertheless, investors should be aware that not all revenue is created equally, and is subject to restatement, especially during times of economic turmoil. Sphere: Related Content

Components of RNOA: Margin and Turnover

Previously, I touched on the importance of Return on Net Operating Assets (RNOA), specifically with respect to my view that it's foolish to examine a firm's ROE without an idea as to the relative contributions of operating and nonoperating returns. I'd like to examine RNOA a bit further, and place some emphasis on it's dual components of margin and turnover. Just to refresh, the original formula for Operating Return is:


RNOA = Net Operating Profit After Taxes / Average Net Operating Assets


In order to illustrate the margin and turnover components, I'll create a new, equivalent equation:


RNOA = (Net Operating Profit Margin / Sales)  X (Sales / Net Operating Asset Turnover)


Therefore:


RNOA = Net Operating Profit Margin (NOPM)  X  Net Operating Asset Turnover (NOAT)


Truthfully, I don't blame you if this still doesn't make a whole lot of sense. So, let's look at this using some real numbers from the largest employer in the world/retail titan..WalMart (WMT).

Above I've included every part of an equation necessary to understand RNOA's components of NOPM and NOAT. Keep in mind that WalMart's RNOA was originally calculated using NOPAT/RNOA, or $15,637/$109,987 to yield 14.22%. To calculate Net Operating Profit Margin (NOPM) I took NOPAT of $15,637 and divided it by 2009 revenue of $401,244. The resulting 3.9% seems rather feeble for such a monster like WalMart; it means that for every dollar of sales revenue, WalMart is only earning 3.9 cents of after tax operating profit. Remember though that the margin is somewhat useless in the absence of turnover figures. To calculate Net Operating Asset Turnover (NOAT), I took 2009 revenue of $401,244 (millions by the way, crazy right) and divided it by Average Net Operating Assets of $109,987. The resulting NOAT is 3.65. Now multiply 3.9 (NOPM) by 3.65 (NOAT); the result should look familiar - 14.2%. Walmart's figures highlight an important concerning the relationship between margins and asset turnover. A high margin firm won't necessarily earn healthy returns for shareholders; it all depends on the turnover they are able to achieve given that level of margin.



I included WalMart's 20.63% ROE just to illustrate that the company is earning a very healthy operating return component of 69% (14.22RNOA / 20.63ROE). Interestingly, the company doesn't highlight this ratio in its financial presentations. Rather, they use a modified return on investment (ROI) formula that takes operating income as its starting point, and adds back in some non-cash adjustments for depreciation and amortization to arrive at the numerator. In the denominator, WalMart creates an average operating assets figure, similar to NOA except that operating liabilities are not netted out of the equation. Although investors should keep an eye on these metrics that are recommended by management, don't forget that they are non-GAAP and are probably suggested for a reason.


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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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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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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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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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Focus on Operating Efficiency: Net Operating Profit Margin

In a previous installment, I covered a measure of after-tax operating profitability known as NOPAT (Net Operating Profit After Taxes). NOPAT serves as a relevant indicator of a firm's ability to operate efficiently, as it strips away many transitory, one-time items from the picture, focusing only on the firm's core business profitability. From an analytical perspective however, NOPAT may be more significant as a numerator of a ratio than as a stand alone measure. One of the most important such metrics is the Net Operating Profit Margin (NOPM).

Calculating the Net Operating Profit Margin is very easy, assuming however that you can properly calculate a firm's Net Operating Profit After Taxes. See this post if you need a refresher on NOPAT. Anyways, below is the formula:

Net Operating Profit Margin = NOPAT / Sales Revenue

Hewlett-Packard (HPQ) FY 2008 NOPM Calculation

Net Operating Profit Margin = NOPAT / Sales Revenue
= $8591M / $118,364M
= 7.26%

To verbalize HP's NOPM of 7.26%, we would say that for every dollar of sales, HP was able to generate 7.26 cents worth of after-tax operating profit. For many companies, operating profit margin may be a more concise measure of performance than the commonly cited Gross Profit Margin. Several small business owners I know are proud of what they perceive to be an impressive gross profit margin at their business. I usually dismiss such talk, as any fool can go out and sell cheaply manufactured products to generate a healthy looking gross profit margin. To pass the NOPM test though, you must be able to operate the organization efficiently and effectively. Because net operating profit margins vary greatly across industries, it's most productive to compare NOPM's across competing organization's within an industry. Below is a focus on HP and it's primary tech industry competitors from a NOPM perspective.

Clearly, industry leaders like IBM and Apple tend to have very healthy net operating profit margins. There's a little bit of "chicken or the egg" dilemma inherent to that observation; i.e. larger industry leaders are better able to exert their will down the supply chain and operate more efficiently.

Although NOPM is only one element that should be considered when evaluating a company's/stock's relative investment attractiveness, it is nonetheless a very insightful indicator of the profitability of a company's operations.The most important analysis that should be performed as a companion to the NOPM calculation is an evaluation of a firm's leverage. NOPM strips out interest expense, effectively looking at the firm from a non-levered position.I'll get into that portion of analysis later via an examination of the debt-to-equity ratio.

*no positions
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Evaluate Operating Performance: Net Operating Profit After Taxes

Although I'm partial towards the use of Operating Cash Flow (OCF) as a primary basis for performance measurement, investors should nonetheless be familiar with Net Operating Profit After Taxes (NOPAT). NOPAT is completely derived from the income statement, subjecting itself to the usual non-cash adjustments dictated by GAAP. However, NOPAT is useful because, as the name implies, it is strictly a measure of operating performance.

Calculation of NOPAT is relatively straightforward, you're simply multiplying Income From Operations Before Taxes by the corporation's effective tax rate. To calculate the tax rate, divide income tax expense by net income before taxes(NIBT); make sure you place NIBT, also known as Pretax Income in the denominator, and not Operating Income. Once you've determined the total taxes owed, you just subtract it from Operating Income to arrive at NOPAT. The two step process is delineated below:

Tax Rate = Net Income Before Taxes / Income Tax Expense
Net Operating Profit After Taxes = Income From Operations Before Taxes X (1-Tax Rate)

*Note that a company's annual reports and 10-Q's will not always show a neatly constructed income statement that spoon feeds you the Operating Income, Pretax Income, and Income Tax Expense lines. GAAP doesn't require the income statement to be constructed in any special sort of way, thus you may have to occasionally deploy some common sense. Nearly all of the time however, websites like Yahoo!Finance and (if you have a subscription) S&P's NetAdvantage will go ahead and break out the necessary line items. The point is, pay attention.

I'll use Hewlett-Packard Company (HPQ) to illustrate an example calculation of NOPAT:
HPQ NOPAT - Year Ended October 31st 2009
Tax Rate = $2144M / $10,473M
= 20.47%

Net Operating Profit After Taxes = $10,802M X (1-.2047)
= $10,802M X 0.7952
=$8,590M

Hewlett-Packard's NOPAT of $8590M compares with net income of $8329M for fiscal year 2008; at only 3% less than NOPAT, 2008 net income is indicative of only a modest amount of interest expense for the year ($329M). The disparity between NOPAT and net income isn't always so minimal, as can be seen in the chart below:
General Electric (GE)'s large disparity between NOPAT and net income is an obvious first observation to make. The primary driver of this phenomenon is the $26,209M worth of interest expense incurred by the company during 2008. The second result of such a massive interest expense is that GE's 2008 effective tax rate was only 5.3% (interest is deductible). The relationship between these two variables will change based upon the industry, and circumstances specific to the company.

*long GE
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Measuring Investment Capacity: Operating Cash Flow to Capital Expenditures

The price that an investor is willing to pay to acquire a share of a corporation's common equity is largely a function of the corporation's potential earnings growth. When purchasing a stock, you are effectively paying for earnings growth in advance of its actual occurrence. At a basic level, in order to grow, a company must be able to invest in both its existing and future property, plant and equipment. A grading contractor who can barely afford the maintenance on his existing machinery will most likely not be expanding the business any time soon. Therein lies the analytical significance of the Operating Cash Flow (OCF) to Capital Expenditures (Capex) Ratio.

Once again, net cash flows provided by operating activities serves as the foundation of this ratio; because non-cash items on the income statement won't exactly help a company purchase a new tract of land or an excavator, we can go ahead an dismiss net income as irrelevant. The point is to isolate the cash generated by a company's operations, and determine whether it is adequate to fund investment in its income producing assets. To calculate the ratio, simply go to the statement of cash flows, and divide "Cash flow from operations" by "Capital Expenditures". A ratio greater than one (1) indicates that a company's operations are generating the cash necessary to fund its annual investment needs. I'll use the cash flow rich Exxon (XOM) as an example:

Operating Cash Flow to Capital Expenditures = Operating Cash Flow / Capital Expenditures
= $59,725M / $19,318M
= 3.09

During fiscal year 2008, Exxon generated over three times the cash needed from operations in order to fund investment in its plant, property and equipment. The chart below compares the ratio for several other companies.

Clearly, some companies are more cash rich than others, and are better prepared to fund growth internally. A ratio of less than one (1) is indicative of a company that may need to borrow money, or that is in decline. I think we all know the story of Blockbuster (BBI); its ratio is so low because it is in decline (to be fair, it is officially in decline from a brick and mortar video delivery standpoint). OCF to Capex is definitely an important ratio that should be part of every investors toolbox. Sphere: Related Content

Operating Cash Flow to Current Liabilities: The Self-Sufficiency Ratio

One of the most fundamental questions we can ask about a company is whether or not it is generating the cash necessary to service its debts. Furthermore, it's important to differentiate between cash generated from operations, and cash generated from financing activities (borrowing or stock issuance); once a company starts raising money for the sole purpose of meeting current debt obligations, we might as well just call it a Ponzi-scheme. To help make that determination, we'll use the Operating Cash Flow to Current Liabilities Ratio.

To calculate the ratio, first locate Net Cash Flow From Operating Activities (CFFO); its found on the statement of cash flows.Next, go to the balance sheet and locate Current Liabilities; this represents debt that matures in one year or less, accounts the company must pay within the year, and the current (one year or less) portion(s) of long term debt.You'll need to calculate the average amount of current liabilities for the period you're examining. Therefore, because the balance sheet represents only a single point in time, you'll need to average the current liabilities section from the two separate balance sheets which mark the beginning and end of the period for which you want to perform the analysis.Divide CFFO by the average current liabilities, and there you have the ratio. Any result less than 1 indicates that the company is not able to liquidate its current liabilities from operating cash flow; in other words, the company will probably have to sell assets, borrow money or issue stock in order to meet its short term debt obligations. (Hence, the "self-sufficiency" title to this post).The 2008-2009 solution is, of course, to conduct a mass layoff. Nothing frees up cash quicker than handing out 10,000 or so pink slips.

One company whose CFFO to Current Liabilities ratio I was particularly impressed with is Intel (INTC). I'll run through the calculation using Intel's numbers below:

Operating Cash Flow to Current Liabilities = Net Cash Flow From Operations / Average Current Liabilities

=$10,926M / ( ($7818M + $8571M) /2)
=$10,926M / $8194.5M
=1.33

As you can see, Intel's ratio of 1.33 stacks up quite favorably against the other companies in the chart below:

Obviously, despite Wal-Mart's poor looking ratio of 0.4, there is no reasonable chance that it won't be able to pay its bills. I imagine that, being the largest employer in America, Wal-Marts wages payable account grows by hundreds of millions of dollars every week. In fact, accounts payable represented around 70% of Wal-Mart's short term debt. As is always the case, this ratio is not a silver bullet, and needs to be used in conjunction with other tools. Sphere: Related Content

Free Cash Flow: The Alternate Bottom Line

One of the themes that I continually emphasize with regards to fundamental analysis is an approach that treats net income as an ancillary, rather than primary, valuation metric. Instead, investors should use Free Cash Flow (FCF) as a starting point from which to assess a company.

Fundamentally, free cash flow is cash generated in excess of a firm's operating costs and capital expenditures (CapEx). Capital expenditures are investments a company makes in its property, plant and equipment. CapEx can be investment in new land, machinery etc., or substantial "repairs" such as putting a new roof on a building. Therefore, CapEx can simultaneously be thought of as investment necessary for growth of the business, and investment necessary for maintenance of the firm's assets. Free cash flow then, is a pure cash measurement that is indicative of the firm's ability to finance expansionary activities from internally generated cash. Conversely, negative free cash flow is potentially indicative of the need for future borrowing.

I prefer to take one additional step in the FCF calculation, and net out dividends. If a company regularly declares dividends, a real cash outlay will occur, and it will detract from the firm's ability to expand operations. You could argue that dividends are voluntary and can be reduced or eliminated; however, that would adversely affect the stock price as the market adjusted to the new, reduced stream of cash flows. The point is, be aware that there are varying definitions of free cash flow. An example of the FCF calculation for General Electric (GE), 2008 reported results follows:

Free Cash Flow = Operating Cash Flow - Capital Expenditures - Dividends
Free Cash Flow= ($48,601M - $16,010M - $12,408) = $20,183M

GE reported $17,410M for its 2008 net income, obviously a couple billion and change shy of its free cash flow generated for the year. The chart below looks at free cash flow v net income at GE and four other companies.
Despite the fact that Exxon (XOM) makes every other industrial corporation look like a mom & pop general store, a major observation to be taken from the chart is that FCF can be either greater, or less than, net income. I wouldn't lay out a bright line rule as to what the ratio between these two should ideally be; the ideal relationship will change depending upon the specific corporation. For instance, Wal-Mart (WMT) primary method of expansion is via construction of new stores, a cash outlay that is already netted out of the free cash flow equation. There might not even be any new ventures for which Wal-Mart would need to apply its free cash flow. A diversified conglomerate like General Electric however, must constantly venture into new business activities, thus necessitating ample free cash flow. The more important point is to look at the FCF trend over time, and within the context of the company's current status. Sphere: Related Content

Earnings Quality Analysis: Operating Cash Flow to Net Income

In my intro to fundamental analysis, I focused on discrediting the P/E ratio as a viable means of gauging the relative value of a stock. The premise behind my campaign of disparagement was that net income, or the "E", is influenced by so many non-cash adjustments as to render its predictive value useless. In general, you could say that my complaints revolve around the concept of "earnings quality" (or lack thereof in many circumstances). Although earnings can consist of both cash and non-cash adjustments, I think we can all agree that earnings based on an increase in a company's cash position are of a higher quality than those which are not. Luckily, there's a useful ratio we can deploy against the income statement to determine the quality of a firm's reported earnings: Operating Cash Flow (CFFO) to Net Income

As the name implies, the ratio is calculated by dividing a company's operating cash flow by it's net income. Operating cash flow is an item found on the Statement of Cash Flows, and is often labeled "Cash Flows Provided by Operating Activities", or "Cash From Operating Activities". Basically, business activities are all placed in one of three categories: Operating, Investing, and Financing. Operating activities are the actions a company takes pursuant to its normal, or core business activities. For instance, a PC company like Hewlett-Packard (HPQ) sells computers and printers as it's core operating activity; if HP sold a piece of land it owned, that cash increase would not appear as cash provided by operating activities. Once you've located your CFFO number, move over to the income statement and find net income. Make sure you use the after tax figure. Divide the two, and there you have your ratio.

Example: Hewlett-Packard (HPQ), 2008 fiscal year totals
Operating Cash Flow: $14,591M
Net Income: $8329M
CFFO to Net Income = $14591M / $8329M = 1.75

The following chart should put HP's 1.75 CFFO to Net Income ratio in perspective; it shows that same ratio for HP and 6 other large tech firms.When a company's CFFO to net income ratio rises above 1, it is indicative of a strong ability to fund it's activities through generation of operating cash flow. In other words, a higher ratio means that the firm's earnings are of a higher quality. Both Apple (AAPL) and Intel (INTC) were able to generate cash from operations that was nearly twice reported earnings. Dell (DELL) however, actually generated less cash from operations than it reported in net income. If I were an investor in Dell, I would probably keep an eye on this ratio in order to determine whether it was a chronic issue at the company. A CFFO to net income ratio which remains below 1 for an extended period of time could be an indication that the company will need to raise money to fund its operations.

Next installment: Free Cash Flow: The Alternate Bottom Line

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Intro to Fundamental Analysis: What's Wrong With the P/E Ratio?

Far too often, the relative attractiveness of a stock is discussed in terms of its price-to-earnings ratio (P/E Ratio). This is an inherently flawed method for determining a stocks value; although the "P" portion of the equation is an objective fact at any given point in time, the "E" is exceedingly more suspect in nature. For those new to this, "P" is the price of the stock, and "E" represents earnings, or net income. To keep things simple, suppose you have a $10 stock, issued by Company X. Let's also say that Company X has earned 25 cents/share each quarter of the past year, and it projects earnings of 25 cents/share for each of the next four quarters. In this situation, Company X will earn $1/share this year. Therefore, at a share price of $10, the stock is trading at 10 times earnings, or a P/E Ratio of 10. Note: Some investors like to use a forward P/E ratio, which basically looks at the next four quarter's worth of estimated earnings to determine the "E". Other fans of the P/E use trailing earnings to calculate the denominator; in other words, the sum of the four most recently reported quarterly per share earnings. I purposefully fashioned my hypothetical Company X earnings report such that both the forward and trailing P/E ratios are 10. This doesn't happen in real life.

Now that everyone is hopefully up to speed, I can get into the real issue here: What's wrong with the P/E ratio? Well, as I said before, the problem is with the "E" or net income. In small business, net income - or more commonly "profit" - is simply the cash left over after you pay the bills. It gets a little more complicated with publicly traded corporations, all of which must adhere to Generally Accepted Accounting Principles (GAAP). Under GAAP, the quarterly income statements that all corporations must file include, and in some cases are dominated by, non-cash items. Let's say a company purchases a tractor for $10,000. Fast forward one year, and the company has accumulated say $900 worth of depreciation on the tractor. That $900 will be recorded as an expense on the income statement, reducing reported earnings despite there never being a $900 change in the company's cash position. As a contrasting example, consider a company that extends credit to a large customer on December 20th, selling $1M worth of software. The seller's assets will increase by $1M via a debit to accounts receivable, and revenue will increase by $1M. Assume that the terms of the sale on account dictate payment within 30 days. For the year ended December 31st, that company will report the $1M as revenue, although they probably won't have received the cash yet.

A further earnings distortion occurs based upon the quarterly price fluctuations of balance sheet assets the company lists as "marketable securities". Often times, a company will use surplus cash to invest in other company's stocks. The change in market value of these securities, whether or not they are actually sold for a profit (or loss), will be recorded as income (or loss) on the quarterly income statement. Obviously, these items are neither indicative of the company's operating performance, nor indicative of changes in its cash position.

Hopefully, by now all readers are appreciative of the reality that a corporation's reported net income is a fickle beast, and that it should not be trusted. Therefore, any ratio whose entire denominator consists only of "net income" should be viewed through a skeptical lens. Don't worry though, as this post is only the first part of the Fundamental Analysis series. Future posts will help investors develop a more holistic and accurate approach to stock analysis and valuation.

Next up in the series: Cash Flow From Operating Activities (CFFO) to Net Income Ratio Sphere: Related Content