Using Financial Reports to Determine a Company's Financial Borrowings and Other Commitments

You can find out a lot about a company's financial management by reading the report notes related to financial commitments. How a company manages its debt is critical to its short- and long-term profitability.

Mattel has one note that summarizes everything under one umbrella called “Seasonal financing and long-term debt.” Hasbro splits this note into two. One is called “Financing arrangements,” for the short-term borrowings and other special arrangements, and the second is called “Long-term debt.”

No matter how a company structures its notes related to financial borrowings and other commitments, as you read the notes, break the information into two piles: long-term borrowings and short-term borrowings. The long-term borrowings involve financial obligations of more than one year, and the short-term borrowings involve obligations due within the 12-month period being discussed in the financial report.

Long-term obligations

For accounting purposes on the financial statements, only two types of debt are recognized: current debt and long-term debt. Current debt is due over the next 12 months, and long-term debt includes debt that a company must pay during any period beyond the next 12 months.

Both medium- and long-term notes or bonds fall into the long-term debt category. Medium-term notes or bonds are debt that a company borrows for two to ten years. Long-term notes or bonds include all debt borrowed for more than ten years.

In the discussion of long-term financial debts, you find two key charts. One chart shows the terms of the borrowings, and the other shows the amount of cash that the company must pay toward this debt for each of the next five years and beyond.

Here, you see Mattel's long-term debt.

Long-term Debt As of Year End 2012 (in Thousands) As of Year End 2011 (in Thousands)
Medium-term notes (6.5% to 6.51%, weighted average 6.53%) due from November 2013 $50.000 $100.000
Senior notes (fixed rate) due March 2013 (5.625%) $350,000 $350,000
Senior notes (fixed rate) due October 2020 and October 2040 (4.35% to 6.2%) $500,000 $500,000
Senior notes due (fixed rate) November 2016 and November 2041 (4.35% to 6.2%) $600,000 $600,000
Less: Current portion (to be paid in 2008) ($400,000) ($50,000)
Total long-term debt $1,100,000 $1,500,000

If a company is managing its debt well, it frequently looks for opportunities to lower its interest expenses. Because interest rates have dropped considerably, when you see interest rates on these charts that are significantly higher than interest rates available in the current market environment, you need to wonder whether the company is doing a good job of managing its debt.

Here, you see Hasbro's long-term debt information.

Long-term Debt As of Year End 2012 (in Thousands) As of Year End 2011 (in Thousands)
6.35% notes due 2040 $500,000 $500,000
6.125% notes due 2014 $436,526 $440,977
6.60% debentures due 2028 $109,895 $109,875
6.3% notes due 2017 $350,00 $350,00
Total notes due $1,396,421 $1,400,872

Short-term debt

Short-term debt can have a greater impact than long-term debt on a company's earnings each year, as well as on the amount of cash available for operations. The reason is that companies must pay short-term debt over the next 12 months, whereas for long-term debt, they must pay only interest and some of the principal in the next 12 months.

The type of short-term debt you see on a firm's balance sheet varies greatly, depending on the type of business. Companies whose sales are seasonal may carry a lot more short-term debt to get themselves through the slow times than companies that have a consistent cash flow from sales throughout the year.

Seasonal companies carry large lines of credit to help them buy or produce their products during the off-season times so they can have enough product to sell during the high season. For example, a company that sells toys sells most of its product during the Christmas or other peak toy-selling seasons; during the other times of the year, it has very low sales.

Another way that firms raise cash if they don't have enough on hand is to sell their accounts receivable (credit extended to customers). A company can sell the receivables to a bank or other financial institution and quickly get cash for immediate needs instead of waiting for the customers to pay.

Be sure to look for a statement in the financial obligations notes that indicates how the company is meeting its cash needs and whether it's having any difficulty meeting those needs.

Lease obligations

Instead of purchasing plants, equipment, and facilities, many companies choose to lease them. You usually find at least one note to the financial statements that spells out a company's lease obligations. Whether the lease is shown on the balance sheet or in the notes depends on the type of lease:

  • Capital leases: These leases provide ownership at no cost or at a greatly reduced cost at the end of the lease. This type of lease appears as a long-term debt obligation on the balance sheet.

  • Operating leases: These leases offer no ownership provisions or provisions that require a considerable amount of cash to purchase the leased item. This type of lease is mentioned in the notes to the financial statements but doesn't appear on the balance sheet as debt.

Companies that must constantly update certain types of equipment to avoid obsolescence use operating leases rather than capital leases. At the end of the lease period, the companies return the equipment and replace it by leasing new, updated equipment. Operating leases have the lowest monthly payments.

When reading the notes, be sure to look for an explanation of the types of leases the company has and what percentage of its fixed assets are under operating leases. Some high-tech companies have larger obligations in operating-lease payments than they do in long-term liabilities. When calculating debt ratios, many analysts use at least two-thirds, and sometimes the entire amount, of these hidden operating-lease costs in their debt-measurement calculations.

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