"Dirty 30" Evaluation Tool Part 4

First off before we begin if you have not read through parts 1,2 & 3 which can be found here. If you have already read through these, then thank you, but also we can proceed onward toward deciphering how I grade stocks before I officially place them into my portfolio. 

Again, here is Hormel (HRL) which we are using as our example for this series.

If you don't remember I layout my analysis in the order that my brain works. Thus, the first thing I want to see are my ratings and projections for the stock. If these are where I like to see them I then look down to my comparative values to see if the market and I are looking at this stock differently. Then my next step brings me to the section that we are going to talk about today: DEBT.

Why do I look at the debt of a company next? Simply put, this is because I want to know how much of the future earnings of the company are already owed. 

Long Term Debt

Long term debt is simply what loans a company has taken out that are not due within the next year. This is always an important number to look at as it shows you what type of repayments are to be made in the future. A company may have no debt to pay off this year but when you look at the year-over-year (YoY) long term debt it may have increased drastically. What does that mean? Well that means that at some point this debt is going to have an effect on future earnings per share (EPS) when it has to be repaid. 

Long term debt though doesn't only include loans taken out by a company. Long term debt also includes any long-term leases that the company has signed. This is especially applicable when dealing with retail or other brick and mortar companies.

 

Current Portion of Long Term Debt

So we talked about the long term debt aspect of the balance sheet but what about the current portion? The current portion is exactly what it sounds like, how much of that long term debt is owed in the next calendar year. Why is this important? Let me give you a quick example.

Say you have a company such as HRL that has long-term debt of $250 million dollars. This company has about 542 million shares and an EPS of $1.64. This equals to about 888.88 million dollars of net profit after it is all said and done. Now notice that the 250 million of long-term debt will not have any owed this year. Let's assume that the market wants to keep it priced at around a 19 price to earnings (PE). That would be about 31 dollars. Now let's say that the income increase at its average of 3.7% and other liabilities, and total shares, stay the exact same over the next five years but all of that 250 million dollars will be paid back at a rate like this:

Year 1 - 50 million
Year 2 - 50 Million
Year 3 - 100 Milion
Year 4 - 25 Million
Year 5 - 25 Million

What would the EPS look like here? 

Year 1 - 888.88 x 1.037 = 921.76 - 50 = 871.76/542 = 1.60
Year 2 - 921.76 x 1.037 = 955.07 - 50 = 905.07/542 = 1.66
Year 3 - 955.07 x 1.037 = 990.40 - 100 = 890.4/542 = 1.64
Year 4 - 990.40 x 1.037 = 1,027.04 - 25 = 1,002.04/542 = 1.84
Year 5 - 1,027.04 x 1.037 = 1,065.04 - 25 =1,040.04/542 = 1.91

How about a constant 19 P/E price of HRL?

Year 1 - $30.40
Year 2 - $31.54
Year 3 - $31.16
Year 4 - $34.96
Year 5 - $36.29

Why do I show you that long drawn out process to let you see what a hypothetical debt repayment cycle could look like in terms of EPS and price per share (pps)? I did this for two reasons. The first is to show you how easily it will be to look at the annual report and calculate exactly how the EPS could be affected by the debt repayment in the upcoming year. The second is to show you that while there are things that can keep a company stock from moving due to EPS, patience can pay off in certain situations. You can't freak out in year three when HRL decides to pay back 100 million of the loans because they know that the EPS will only move a couple of cents in the negative direction. This is a hypothetical example but this is how companies do think a lot of the time. Instead of basing everything off of EPS and saying "Oh no, they have a declining EPS I need to sell!" You could read a bit deeper and realize that it is actually a buying opportunity with about a 16% potential 2 year gain!

 

Capital Lease Obligations

The capital lease obligations is where companies list leased assets that they are currently paying off. What is the importance? Well these obligations, while an expense, can be labeled as repayments of long term debt. Why is that important?

Well let's say that you own a lemonade stand competing against your neighbor's lemonade stand. You are reporting that your operating cash flow has risen from $1000 to $2000 over the past year while he is stating that his operating cash flow has increased from $1000 to $1300. Pretty great news for you and your shareholders!

Not so fast.

Your neighbor entered into an operating lease to pay a monthly fee for all of his equipment. He pays $700 each year for the past two years and it is listed as an operating expense. You, on the other hand, payed $700 dollars in operating leases last year but decided this year to change to a capital lease for the same $700. 

How can this skew the balance sheet? When looking at increases in operating cash flow, or money made available by what the company actually does, you do not have to report a capital lease as an operating expense like you do with an operating lease. Since a capital lease is technically something that you "own" under a loan this can be labeled as a repayment of long-term debt. That being said what does this make our operating cash flow actually look like between the lemonade stands, if the lease repayments are treated as equal?

Your Neighbor
2016 - 1700 sales minus 700 in expenses = 1000
2017 - 2000 sales minus 700 in expenses = 1300
Net Gain in Operating Cash Flow - 30%

You
2016 - 2000 sales minus 700 in expenses = 1300
2017 - 2000 sales minus 700 in expenses = 1300

Sorry amigo but I am taking your friend's stand since it has 30% growth.

My point is just that when I see huge sums or increases in capital leases it raises a red flag that I at least need to check out the balance sheet and see if the operating cash flow looks like it is being accounted for without any sleight of hand. Did you really sell enough lemonade to show significant growth or are you just showing me what I want to see?

 

Accrued Payroll

This one doesn't really have any silly examples but is simply a way for me to take a look at potential risks of the company in the near future. Hiring people is great and all but a large increase in workers could come at a major cost if it is in a state that is now raising minimum wage. If you rely on workers making $9/hr but the state decides to make minimum wage $15 dollars that could put a pretty big hurt on the cash flow. Again this isn't a major issue, but it is one that you need to take a look at.

 

Interest Expense

This goes right along with the long term debt. How much a company pays is interest is pretty important in terms of future cash flow and earnings. If a company has been paying $10 million in interest each year then suddenly has $13 million to pay next year that could potentially cause some major movement to the stock price. If it continues to issue debt you need to be aware of what the exact terms are and how much they will be paying in interest each year.

 

Current Ratio

Current ratio is a fairly simplistic thing to wrap your head around. Current ratio is all current assets divided by all current liabilities. A ratio of under 1 can be plenty worrisome if the economy takes a downturn. With a high ratio (I go old school Graham here and look for 2 or more) it is more likely that if something catastrophic happens then the company will have a better chance of not drowning. Also in terms of dividend paying companies, which I only invest in, this may mean less of a chance of a dividend cut during a tough economic time.

 

Quick Ratio

This is a lot like current ratio but instead takes away inventories held by companies.

(current assets - inventories)/current liabiliies

This gives a quick look at everything a company can use immediately to pay off all of their liabilities. Think of this like you would your credit card bill. If I have a credit debt of $10,000 but only have $5,000 in cash or equivalents then my quick ratio would be 0.5. You probably wouldn't be too confident in me paying it back immediately if I had to unless I sold my car. Now without a car how do I get to work? Without work how do I pay my other bills? 

Okay that was a bit of an extreme example but you get where I am going and also can see why I like to see a quick ratio over 1...you know, just in case.

 

Conclusion

That ended up being a lot longer than I was anticipating but I hope I cleared up why exactly my debt section looks the way it does. As always feel free to leave any questions or comments in the section below!