Financial Education

Consider two companies, Arkansas Best and Landstar Systems, both of which are classified as trucking companies. According to Landstar’s 10K filing for the year ended December 30, 2006 (p. 5), “The carrier segment markets its services primarily through independent commission sales agents and utilizes Business Capacity Owner Independent Contractors and Truck Brokerage Carriers. Using a stylized example:

Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.

The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.

Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. This can be seen from the Arkansas Best example, where adding capacity caused the “fixed” costs to rise at a higher rate than revenues in 2006. It can be difficult even for someone inside the firm to accurately measure fixed costs versus variable costs. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:

(Percentage Change in Operating Income)/(Percentage Change in Revenues)

For Arkansas Best, if we assume that the change between 2004 and 2005 represents a “normal” level of operating leverage (in reality a longer data series would be needed) we can approximate the operating leverage as 8.2%/6.0% = 1.37 or 137%. A 10% increase (decrease) in sales would result in a 13.7% increase (decrease) in operating profit.

It is unrealistic to expect fixed costs to remain constant indefinitely. As the company grows, fixed costs may need to be increased periodically in a stepwise manner. For example, headquarters administrative costs might be fixed for a company’s current level of production and for small increases in production. However, if production were doubled, some of these fixed costs might increase.

For Arkansas Best, it wasn’t an actual increase in sales but planning for anticipated future increases that hurt margins in 2006. If we calculate the operating leverage from 2005 to 2006 we get 6.2%/9.5% = 0.65. Operating leverage less than 1.0 implies that profitability declines when sales increase. This is clearly not normal. In future years, the company’s profit margin should improve as sales grow into the new fixed costs. At some time in the future, though, the company will again reach a level of activity where fixed costs must increase, and the profit margin would generally be expected to decline in that year.

Operating leverage can be measured if the breakdown of fixed cost and variable cost in a company’s operating structure is known. Operating leverage is normally based upon operating income to avoid muddying the signal with financial leverage or taxes.

Computing operating leverage would be easy if the proportion of fixed and variable costs could be known with certainty. Consider a stylized example:

Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.

The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.

Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:

Percentage Change in Operating Income

Percentage Change in Revenues

Contribution margin is revenue less any variable costs such as sales commissions. Since variable costs rise and fall at the same rate as revenue, the more revenue earned the more the associated costs. All non-variable expenses will have to be paid from what is left, the contribution margin.

Fixed costs are expenses that stay relatively constant within a given level of sales. For example, the cost of renting a corporate headquarters is likely to be a constant amount (say, $100,000 per month) regardless of how much revenue the company generates.

Variable costs, as the name implies, vary with the amount of revenue. A good example is sales commissions. More commissions will be paid if the company generates $2 million in sales than if it generates $1 million.

Companies have a fair amount of discretion regarding how they will estimate their losses from customers who fail to pay, and when they will recognize the losses. This article, originally published at Stock Market Beat and reprinted here with the author’s permission, offers a nuts-and-bolts explanation of how investors can make any necessary adjustments. Another article at Stock Market Beat explains why this is important.

When a company records a sale, if it has not yet collected the proceeds it records an account receivable on the balance sheet. Sometimes the company is unable to collect its receivables, and they have to be written off as a bad debt expense. To prepare for this contingency, companies create a reserve account known as the allowance for doubtful accounts, where they estimate how much of their receivables will not be collected and exclude that amount from being recognized on the income statement. If in fact the receivable is not collected it is charged against the reserve account rather than appearing on the income statement at that time. Because the amount reserved in any period is subject to management’s discretion, it is an area that can be used to manipulate earnings. Even when management is completely scrupulous the allowance for doubtful accounts can be an early warning indicator for potential problems.

As noted above, management has some discretion as to how much of a reserve should be taken in a given accounting period. We have discussed similar issues with respect to financial receivables for companies that lease or finance sales to customers. We have also commented in several posts about companies that may be under-reserving their allowance for doubtful accounts. Here we explain how to analyze this account more fully.

Management’s discretion has certain limitations. The amounts recorded in reserve accounts has to be explained to auditors, and generally follow some guidelines. Sometimes it can be a simple percentage of sales or gross accounts receivable that is assumed will not be collected based on prior history. Sometimes the system may be more complicated, as described in the disclosures below, which were taken from Fidelity National Information System’s (FIS) recent 10Q:

Since the Merger with Certegy, the Company recognizes a reserve for estimated losses related to its card issuing business based on historical experience and other relevant factors. The Company records estimates to accrue for losses resulting from transaction processing errors by utilizing a number of systems and procedures in order to minimize such transaction processing errors. Card processing loss reserves are primarily determined by performing a historical analysis of loss experience and considering other factors that could affect that experience in the future. Such factors include the general economy and the credit quality of customers. Once these factors are considered, the Company assesses the reserve adequacy by comparing the recorded reserve to the estimated amount based on an analysis of the current trend changes or specific anticipated future events. Any adjustments are charged to costs of services. These card processing loss reserve amounts are subject to risk that actual losses may be greater than estimates.

In the Company’s check guarantee business, if a guaranteed check presented to a merchant customer is dishonored by the check writer’s bank, the Company reimburses the merchant customer for the check’s face value and pursues collection of the amount from the delinquent check writer. Loss reserves and anticipated recoveries are primarily determined by performing a historical analysis of our check loss and recovery experience and considering other factors that could affect that experience in the future. Such factors include the general economy, the overall industry mix of customer volumes, statistical analysis of check fraud trends within customer volumes, and the quality of returned checks. Once these factors are considered, the Company establishes a rate for check losses that is calculated by dividing the expected check losses by dollar volume processed and a rate for anticipated recoveries that is calculated by dividing the anticipated recoveries by the total amount of related check losses. These rates are then applied against the dollar volume processed and check losses, respectively, each month and charged to cost of revenue. The estimated check returns and recovery amounts are subject to risk that actual amounts returned and recovered may be different than the Company’s estimates.

However, even in these more complicated cases, the investor can compare the current allowance to past results based on a percentage of sales or receivables to gain insight as to trends. If the allowance is rising or falling at a significantly lower rate than sales it should tell the investor to take a closer look and figure out why.

When the amount being reserved is falling as a percentage of sales or receivables, the result is higher net income than there would have been using a consistent reserve percentage. It is easy to see how management might have an incentive to post higher earnings, so frequently this is the focus of investor concern. However, in the case of FIS we see the opposite trend: the allowance increased 51 per cent, compared with a 23 per cent increase in receivables. Sequential rise in sales cannot be determined due to the accounting treatment of the reverse acquisition of Certegy. The higher allowance for doubtful accounts in the period resulted in EPS being $0.02 lower than would have been reported had the allowance stayed at a consistent percentage of total accounts receivable.

There are several possible explanations for a significant increase in the allowance for doubtful accounts relative to sales or receivables:

1. Something has changed. This may be the cause for the rise in FIS, as the company acquired Certegy in a reverse merger during the quarter. Certegy’s check guarantee business could very well have a higher incidence of uncollectible receivables than the legacy FIS business. (Note that this may not be a bad thing if the profitability is high enough to offset the higher incidence of bad debt.)
2. The company is actually seeing higher than normal losses from uncollectible receivables. This is also possible in the case of FIS, as the allowance is set partially based on an estimate of current trends. Higher than normal levels of uncollectible receivables could be due to just random luck, but could also indicate the company is pursuing higher-risk customers. In the latter case, it would indicate a lower quality to recorded sales and earnings.
3. The company is doing well and management wants to set aside reserves for a rainy day. This would be a case of earnings management in which the company has perhaps done better than expected and uses the opportunity to pad reserves in case they want to tap into them in a tougher period.
4. The company is doing poorly and wants to take all its lumps and make future performance look better. This is known as taking a big bath. If the company has no chance to make expectations it may want to set aside extra reserves and take a bigger hit today in order to set up easier comparisons in the future. Since FIS has a number of restructuring and merger charges in the current period, as well as the new requirement to expense stock options, this is yet another possible explanation of the rise in the allowance for doubtful accounts.

Investors should call the company or otherwise try to figure out what is behind any large change in the allowance for doubtful accounts relative to sales and/or receivables.

When investors are unsure about a company’s prospects and want to evaluate them under a variety of circumstances, it can be useful to perform a sensitivity or scenario analysis. One example of such an analysis was originally published at Stock Market Beat, and is reprinted here with the author’s permission.

In previous posts we have discussed Ceradyne’s (CRDN) increased reliance on military body armor for revenue and the potential consequenses should orders flatten or, worse, decline significantly once the military has all the units it needs. In the latest quarter, military sales made up 80 per cent of CRDN’s overall business. Because the issue is so important for potential Ceradyne investors, this article conducts a sensitivity analysis on Ceradyne’s sales and earnings.

When a company increases its sales, most of the time its earnings can grow by a greater amount. This is because some of the company’s costs are fixed and do not fluctuate with the level of sales. This factor is called the operating leverage effect (OLE). According to The Analysis and Use of Financial Statements, (p. 138) OLE can be estimated as the percentage change in operating income divided by the percentage change in sales.

Looking at the last three years for Ceradyne, we find an approximate OLE of 130%, which suggests that each 10 per cent change in CRDN revenue will result in a 13 per cent change in operating income. Using that, we can now create some basic scenarios for the company. First, we will assume that 2006 results are in line with management’s guidance (which implies a 170 per cent OLE in 2006.) Given the range of OLE estimates we have seen, we will settle on 150 per cent for our analysis. From there, we will start with three scenarios for 2007:

1. Base Case: After 2006, military sales are flat as replacement units make up for the initial order fulfillment. The rest of the company can grow 15 per cent. Due to the 80/20 mix of military/other, this translates into total revenue growth of three per cent.
2. Bull Case: After 2006, military sales rise at the company-average 15 per cent per year due to technological advances the military needs or market expansion (i.e. into vehicle armor.) This would mark a total revenue growth rate of 15 per cent.
3. Bear Case: After 2006, with the initial order filled, there is a 50 per cent drop in military orders, but the remainder of the business continues to grow 15 per cent. Given the 80/20 revenue mix, this would mean an overall sales decline of 37 per cent.

For those who fear the bear case is too… well, bearish, note that the latest 10Q warns:

Based on our current backlog, we expect our shipments of ceramic body armor to be higher in fiscal year 2006 than in 2005. However, unless we receive additional orders under existing contracts or are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor will decline materially in 2007 from levels we expect to achieve in 2006.

On the other hand, the bull case is also possible. For example, Newsday recently reported that the Army is seeking a replacement design for the current body armor vest. Ceradyne could potentially win this design, although the upside to such a win is uncertain given that Ceradyne already makes the armor plating that is inserted into the current generation vest.
Finally, in Q12006, operating income more or less equaled net income. This is because the interest earned on cash was enough to offset interest paid on the company’s convertible bonds. So, after applying the 36.5 per cent tax rate we should be at a rough estimate of net income for each case. So let’s see them:

So now we have a set of three potential outcomes for Ceradyne in 2007. You can assign your own weight to each potential outcome, or play with the scenarios. But at least it should now be apparent that the $3.54 consensus estimate for 2007, and even the $3.15 to $4.27 range, are subject to a good deal of uncertainty.

Our article on equity income from affiliates described the income statement treatment for investments a company makes that result in it owning a significant amount of the investee, but not enough to treat it as a subsidiary. In accounting for business combinations we showed what can happen when companies report similar investments using different accounting methods. What follows is an excerpt from an article originally posted at Stock Market Beat discussing generally how to analyze the income statement of a company that has unconsolidated affiliates.

Xerox’ participation in the Fuji Xerox JV is accounted for using what is known as the equity method. According to the company’s latest 10K, “Equity in net income of unconsolidated affiliates of $114 million, principally related to our 25% share of Fuji Xerox income, which increased by $16 million in 2006 as compared to 2005, primarily due to improved operational performance.” In both 2005 and 2006 the Fuji Xerox venture contributed nearly 10% of the net income reported by Xerox, without muddying up the “revenue” or “expense” lines.

It is a simple adjustment, however, to see how net margin would be affected by looking at only the operations for which Xerox fully reports results. All that is needed is to subtract “equity in net income of unconsolidated affiliates” from net income, which we do in the table below.

As expected, net margin is lower when you take out portions that are treated as 100% profit (all costs are off the financial statements.) There is also a smaller improvement in margin (130 basis points rather than the 140 reported) in 2006, but a larger one in 2005 when adjusted numbers are used. In addition, the growth in net income is higher in both periods when using the adjusted number. Overall, this analysis tells us that the company’s non-JV business was starting in worse condition that was apparent, but showed more significant improvement relative to taking the numbers at face value.

By understanding how the accounting requirements as well as any management discretion used when applying them, investors can piece together more of the puzzle.

Gross profit is computed as sales, less the cost of those sales. This provides a basic measure of a company’s operating performance. Some companies use a single-step format and do not break this out as a separate line item, though it can easily be calculated from the information given. Instead, the single-step format lumps all operating expenses (other than taxes) together.

By contrast, the multiple step format provides subtotals for important items. For example, sales less cost of sales would be presented as gross profit. Both formats are acceptable in practice, although the multiple-step format is more useful.

Suppose someone told you that a particular company had $1 billion in earnings one year. Is that good or bad? The answer depends on many factors, including:

• How much revenue did the company book in order to achieve those earnings?
• How much did competitors of a similar size earn?
• How much did the company earn last year?

How can an investor fairly compare one company’s earnings to another, given that they cannot be exactly alike in all other respects? How can the firm’s performance be compared to its past performance to determine whether it is improving? Common size analysis is one tool that allows investors to compare companies across time and with other companies.

The following articles explain how to use common size analysis in practice:

1. Vertical Common Size Income Statements shows how to express the income statement as a percentage of sales and use this data to analyze a company’s performance over time.
2. Horizontal Common Size Income Statements demonstrates how to express the financial statements in each year as a percentage of a given base year. This permits an investor to see if certain expenses, assets or liabilities are growing faster than others.
3. Common Size Balance Sheets can be used to compare companies even when they use different currencies.
4. Using Common Size Statements to Forecast Earnings shows how to do just that.

Vertical common size financial statements remove the impact of size by expressing each line item as a percentage of a reference item, usually sales or assets. In a spreadsheet this can be done simply by dividing each line item by that year’s net revenues figure. Consider the following, which is the 3-year income statement presentation for Plantronics, Inc. included in their 10K statement filed June 5, 2006.

We can see right away that in Plantronics’ 2006 fiscal year its net income fell even though revenues increased significantly. However, it is not so easy to tell exactly why the performance deteriorated. Now consider the same statement expressed in a vertical common size format.

Presented in this format, it is easy to see that a significant increase in the cost of sales relative to total sales drove declining profit margins.

See also:
Common Size Financial Statemtents
Vertical Common Size Balance Sheets
Horizontal Common Size Income Statements