We also highlighted Delta’s increase in “Prepaid expenses and other” because this innocent-looking account contains the fair value of Delta’s fuel hedge derivatives. Here’s what the footnote says:

Prepaid expenses and other current assets increased by 34%, or $120 million, primarily due to an increase in prepaid aircraft fuel as well as an increase in the fair value of our fuel hedge derivative contracts…. Approximately 65%, 56% and 58% of our aircraft fuel requirements were hedged during 2003, 2002 and 2001, respectively. In February 2004, we settled all of our fuel hedge contracts prior to their scheduled settlement dates… and none of our projected aircraft fuel requirements for 2005 or thereafter.

The rules concerning derivatives are complex, but the idea is this: it is entirely likely that working capital accounts contain embedded derivative instruments. In fact, the basic rule is that, if a derivative is a hedge whose purpose is to mitigate risk (as opposed to a hedge whose purpose is to speculate), then the value of the hedge will impact the carrying value of the hedged asset. For example, if fuel oil is an inventory item for Delta, then derivatives contracts meant to lock-in future fuel oil costs will directly impact the inventory balance. Most derivatives, in fact, are not used to speculate but rather to mitigate risks that the company cannot control.

Delta’s footnote above has good news and bad news. The good news is that, as fuel prices rose, the company made some money on its fuel hedges, which in turn offset the increase in fuel prices–the whole point of their design! But this is overshadowed by news which is entirely bad: Delta settled “all of [their] fuel hedge contracts” and has no hedges in place for 2005 and thereafter! Delta is thus exposed in the case of high fuel prices, which is a serious risk factor for the stock.

Summary

Traditional analysis of working capital is defensive; it asks, “Can the company meet its short-term cash obligations?” But working capital accounts also tell you about the operational efficiency of the company. The length of the cash conversion cycle (DSO+DIO-DPO) tells you how much working capital is tied up in ongoing operations. And trends in each of the days-outstanding numbers may foretell improvements or declines in the health of the business.Investors should check the inventory costing method, and LIFO is generally preferred to FIFO. However, if the LIFO reserve drops precipitously year over year, then the implied inventory liquidation distorts COGS and probably renders the reported profit margin unusable.

Finally, it’s wise to check the current accounts for derivatives (or the lack of them, when key risks exist) and off-balance sheet financing.

Taken From : Advanced Financial Statements Analysis

This entry was posted on Thursday, November 27th, 2008 at 2:16 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.