accurately judge the effectiveness of internal controls, how can you determine whether expansion is reasonable? In a well-managed corporate environment, a reserve for bad debts is set up in the cur- rent assets section, as a reduction of accounts receivable—and this negative asset should remain at approximately the same relative level even when revenues and receivables are expanding. When you see the percentage increasing, it indicates that the company is not controlling collections as effectively as it did in the past.
3. Average time required to collect outstanding accounts. Another trend that reveals a lot is the average time required to collect money from customers. As the time receivables are outstanding grows, it becomes likely that the company will also experience higher bad debts. In some industries such as financial companies, this type of information is readily available. In some other indus- tries, it might not be as easy to find. So as a practical matter, be aware that you might not find direct evidence of changes in in- ternal policies. Nevertheless, you can draw reasonable conclu- sions about these accounts by observing rapid expansion of accounts receivable and higher bad debt reserves. The average time works as a confirming indicator, but it is not always easy to find on the annual or quarterly reports, or in the footnotes.
capitalization, which is the overall dollar value of common stock’s issued shares. Information about total shares is found in the balance sheet and its footnotes. If the value of market cap is not pro- vided directly as of the date of the financial state- ments, it is easily calculated. Simply multiply the number of issued common stock shares by the mar- ket price per share. Because both numbers of shares and market price may change over time, market cap is not a stationary number. As a means for comparing overall market value of a company, you may think of market cap as the actual value of com- mon stock. This information is very significant for all stocks included in indices; the larger the market cap, the greater the company’s influence on the index. Market cap is also useful for comparisons between corporations within the same industry or for use in calculating various kinds of returns (e.g., return on earnings or investment).
The second definition of capitalization refers to quite a different matter, the distinction and trend between equity and debt. When a corpora- tion’s overall capitalization is discussed, it includes two sources. First is equity, or ownership, which is represented by the value of the net worth section of the balance sheet (all shares of stock plus retained earnings and adjustments). Second is debt, which is represented by long-term liabilities consisting of both long-term notes payable and bonds. Together, equity and long-term debt comprise the capitaliza- tion or the source of money that funds growth and ongoing operations.
The analysis of capitalization and tracking changes between equity and debt is crucial, not only to working capital health, but also as a mea- surement of planning and cash control. The debt ratio, often also called the debt-equity ratio, tracks debt as a total of capitalization. Increases in the per- centage of debt are considered negative. As debt
market capitalization the market value of all common stock issued and outstanding, com- puted by multiply- ing total common shares by the current market price per share.
equity the value of own- ership; in a listed corporation, eq- uity consists of all classes of stock plus retained earnings. Equity investors are compensated by way of dividends and long-term capital gains.
issued shares
common stock of a listed corpora- tion available for public trading, including closely held shares owned by direc- tors, officers, and founding family members, and the value of shares that may be is- sued in the future to honor outstand- ing stock options.
grows over time, future dividend payments to stock- holders are likely to be replaced by ever-growing interest to debtors, as well as further cash flow strain when bonds and other long-term debts be- come due.
The formula is straightforward. Add up total capitalization (C ) (long-term debt and sharehold- ers’ equity); and then divide long-term debt (D) by the total, with the answer expressed as a percentage (R, or ratio):
D ÷ C = R
A potential danger to long-term growth is found in cases where debt capitalization grows over time. During periods when revenues and earnings are down, there may be a tendency for corporate management to fund operations by increasing long-term debt rather than cutting expenses and consolidating operations. This decision has nega- tive long-term ramifications and, without the debt ratio, it may be invisible. For example, if you judge working capital with the current ratio alone, you might never even notice that equity capitalization is being replaced with long-term debt. As mounting net losses continue and equity declines, the corpo- ration may continue to fund its operations and to bolster working capital by accumulating more and more debt.
C a p i t a l i z a t i o n : D e b t a n d E q u i t y 149
debt
the value of lia- bilities of a corpo- ration; to an in- vestor, the value of bonds owned.
Bond investors receive compen- sation by way of interest, as well as discounted value of the bond based on interest rates paid versus cur- rent market rates.
long-term notes payable debts of a corpo- ration that are payable beyond the next 12 months, including intermediate-term loans, mortgages, and long-term obligations.
bonds
for corporations, long-term debts payable with interest to debt investors; for investors, an alternative form of investment includ- ing a promise for repayment of principal as well as periodic pay- ments of a stated and fixed rate of interest.
Watching how companies manage long-term debt provides you valuable information about long-term value, such as the degree of earnings that will be available to pay future dividends to stockholders . . . or interest to bondholders.
Key Point
For example, an initial review of Motorola’s balance sheet (http://www.motorola.com) over a six- year period reveals some interesting outcomes (see Table 7.1).
These results appear quite promising, as long as the working capital analysis is limited to the cur- rent ratio. In fact, it appears that matters have im- proved significantly. But there is a puzzle. Through 2002, Motorola reported substantial net losses; so how could working capital improve while the com- pany was losing money? In fact, a review of the debt ratio answers this question. During the same period, the debt ratio changed as well (see Table 7.2).
debt-equity ratio
alternate name for the debt ratio;
a ratio demon- strating relation- ships between debt and equity capitalization.
TABLE 7.1 Motorola’s Balance Sheet, 1999–2005 (in millions)
Current Current Current
Year Assets Liabilities Ratio
1999 $17,585 $12,906 1.4 to 1
2000 19,885 16,257 1.2 to 1
2001 17,149 9,698 1.8 to 1
2002 17,134 9,810 1.7 to 1
2003 7,856 9,381 1.9 to 1
2004 21,115 10,606 2.0 to 1
2005 (6 mos.) 23,216 10,674 2.2 to 1
TABLE 7.2 Motorola’s Debt Ratio, 1999–2005 (in millions)
Long-Term Total Total Debt
Year Debt Equity Capitalization Ratio
1999 $3,089 $18,693 $21,782 14.1%
2000 4,293 18,612 22,905 18.7
2001 8,372 13,691 22,063 37.9
2002 7,189 11,239 18,428 39.0
2003 9,976 12,689 22,665 44.0
2004 6,985 13,331 20,316 34.4
2005 (6 mos.) 6,944 14,608 21,552 47.5
This changes the picture considerably. Long-term debt doubled through the period, while equity declined by $4 billion. Total capitaliza- tion was approximately the same by mid-2005 as it has been at the end of 1999; but the debt ratio increased from 14.1 percent of the total to nearly half, at 47.5 percent.
So the appearance that working capital remained healthy—as mea- sured by the current ratio—is deceptive. You also have to consider that shareholders in this company have to repay the long-term debt that was accumulated at the expense of equity capitalization. In a very real sense, the declining availability of future working capital—brought about by ever-growing long-term debt—may mean lower future dividends. For any stockholders who consider dividend trends an important aspect of valuation, the problem of growing long-term debt may be more impor- tant than earnings over the long term.
The previous example demonstrates the complexity of fundamental analysis. If you limit your review to only one indicator, you have no way to ensure that the results are reliable. In this case, it is perplexing that the cur- rent ratio remained strong even while the company reported large net losses.
The explanation was found in the replacement of equity with debt, a prob- lem that will plague working capital and cash flow for many years to come.