In the Financial Statement Analysis Module, the sub branch “Analyzing Operations” is organized around two sub-sections:
Working Capital
Asset Turnover
Working capital deals with the day-to-day operations of the firm including accounts receivables, accounts payables and inventory. Ratio analysis applied to working capital is often referred to as “Activity Analysis” which deals with re-expressing the day-to-day operations relative to Sales revenue in terms of turnover ratios and re-expressing turnover ratios in units of time (i.e., days to pay payables, days to sell inventory, days to collect receivables). Activity analysis is important for evaluating how efficiently a firm’s operating cash flows are being managed. Activity analysis ratios combine income statement information such as Sales Revenue and Cost of Sales with average balance sheet information to extract important insights.
A second component for analyzing operations is to consider the impact of sales revenue on non-current assets. Here an analyst is applying ratio analysis to assess how efficiently a firm’s fixed assets are being utilized relative to the sales revenue being generated.
Working Capital
Working Capital is defined as Current Assets minus Current Liabilities net of financing and tax related activities. This leads to eliminating items such as short term debt and the current portion of long term debt as well as deferred tax assets/liabilities. The problem group is cash and marketable securities. The last group is usually split between the financing and investment decisions, but predominately is influenced by the financing decision. As a result, the usual simplifying assumption is to eliminate cash and marketable securities from working capital. With these eliminations it largely consists of: Accounts Receivable, Inventory and Accounts Payable. These major components lead to the three major turnover ratios.
Turnover Ratios
These ratios relate income statement information to balance sheet information. The numerator of these turnover ratios is usually defined relative to their closest driver. For example, Accounts Receivable is driven by Sales on Account and therefore Net Credit Sales is used in the numerator if available otherwise Sales. Similarly, under historical cost accounting Inventory as measured on the balance sheet is more closely aligned with the Cost of Goods Sold (COGS) to an external analyst. Finally, Accounts Payable is driven by Purchases and so either Purchases if available or COGS is used in the numerator for this ratio. Formally, we can define them as follows:
Accounts receivable turnover = Sales/Average Accounts Receivables
Inventory turnover = COGS/Average Inventory
Accounts payable turnover = Purchases/Accounts payable or otherwise COGS/Average Accounts Payable
There are variations to the above definitions that do not use the “Average” but instead just use the end of period balances. What is important is to be consistent in the application of the definition given available data. The required reporting format for the Consolidated Balance Sheet in a 10-K is to provide investors with both the beginning and end of period account balances and so the average is then defined as (Beginning plus End of Period Balance)/2 in the above definitions. Conceptually, this reflects the fact that Sales Revenue is usually generated relatively evenly over the year.
Converting Turnover Ratios into Days
If the accounting period is defined as 1-year (e.g., if the financial statements are obtained from the 10-K) then turnover ratios can be expressed in terms of number of days by dividing by the turnover ratio by 365:
Number of days to Collect Accounts Receivable = 365/Accounts receivable turnover
Number of days to Sell Inventory = 365/Inventory turnover
Number of days to Pay Creditors =365/ Accounts payable turnover
Example: Working with the 10-Q
Suppose you are working with a 10-Q which is a quarterly financial report. Typically in the 10-Q the latest quarter results are provided as well as the latest 6-months or 9-months is sometimes provided. For example, 1-800 Flowers provides both 3- and 6-month data as follows:
The three months revenue number is $179659 in thousands.
The quarterly balance sheets often do not provide the opening and closing balances for three months and so additional quarterly balance sheets need to be brought up to align the time around the beginning and end of period balances. This is illustrated for 1-800 Flowers as follows:
Here the last two quarterly reports are required to get to the beginning and end of quarter balances for accounts receivable:
End of period is April 1, 2012: $21477
Beginning of Quarter is Jan 1, 2012: $30078
Average for the quarter is: (21477 + 30078)/2 = $25,777.5
Accounts Receivable Turnover = 179659/25777.5 = 6.97
Days to Collect Accounts Receivable (assuming 91 days between April 1, 2012 and January 1, 2012) = 91/6.97 = 13days.
Number of days to Collect Accounts Receivable = 91/Accounts receivable turnover
Number of days to Sell Inventory = 91/Inventory turnover
Number of days to Pay Creditors =91/ Accounts payable turnover
Operating Cycle
Operating Cycle = Number of Days to Sell Inventory + Number of days to collect accounts receivables
The operating time cycle measures the time taken from inventory acquisition to collecting cash. That is, it is sum of the days taken to sell inventory and the days taken to collect cash from accounts receivable. This measure can be sensitive to the business cycle such that operating cycles lengthen in recessions and shorten when economic growth is strong.
Cash Conversion Cycle
The cash conversion cycle is defined a little more broadly than the operating cycle. The cash conversion cycle includes accounts payable so that it includes resources associated with the acquisition and selling of inventory or service provision. That is, the number of days required to convert resources associated with operations to cash. Usually, the shorter the cash conversion cycle the better.
Calculating the Cash Conversion
First, calculate the accounts payable turnover by dividing the cost of goods sold by accounts payable. Next, divide 365 days by the accounts payable turnover to determine the days' payables outstanding. To determine the cash conversion cycle, first add the days' sales outstanding and the days' sales in inventory, and then subtract the days' payables outstanding. The resulting cash conversion cycle measures the time period between the cash outflow for materials required for the production of a product or service and the cash inflow from sales. A decrease in the cash conversion cycle can lead to an increase in the operating profit margin. Finally, the Cash Conversion cycle is then the aggregate number of days for collecting accounts receivable plus the number of days required to sell inventory minus the days to pay creditors.
Cash Conversion Cycle = Number of Days to Sell Inventory + Number of days to collect accounts receivables – Number of Days to Pay Payables
The cash conversion cycle is closely related to the firm’s credit policy for accounts receivable as well as the credit policy given to the firm for accounts payable. For example, Amazon has an aggressive business model that generates a negative cash conversion cycle given the float it receives from its creditors.
Asset Turnover
The objective for constructing asset turnover ratios is to measure how efficient management is using its assets. Again, interpretation is on a relative basis that varies across industries and sectors. The higher the number the more efficient asset utilization is.
The three main measures span both fixed and current assets:
Average working capital turnover = Sales / Average working capital
Average fixed asset turnover = Sales / Average fixed assets (net plant property and equipment)
Average total asset turnover = Sales / Total Assets
Each measure reveals for $1 of denominator (Average Working Capital or Average Net Plant Property and Equipment or Total Assets) what dollar amount of sales revenue was generated.
Example:
In their Dec 31, 2011 10-K Intel disclosed the following numbers for their Property, Plant and Equipment (PPE) and Sales Revenue:
Average PPE: $20,763 in millions
Sales Revenue: $53,999 in millions
Average fixed asset turnover = 53,999/20,763 = 2.6007
That is, for every $1 of average PPE Intel generated $2.60 in sales.
