Financial Education

Just as common size financial statements improve comparability of performance over time and across companies, ratio analysis is another important tool for investors. Although common size analysis typically focuses on a particular financial statement (income statement, balance sheet, etc.) the full array of ratios also permits the investor to evaluate factors that affect multiple statements simultaneously.

Ratios are generally grouped into the following categories:

• Activity ratios indicate how efficiently and effectively a company manages its operations and assets.
• Liquidity ratios demonstrate the firm’s ability to meet its immediate obligations.
• Solvency ratios indicate whether the firm can meet its long-term obligations.
• Profitability ratios illustrate whether the company can cover its costs and have money left over to reinvest in growth opportunities.
• Cash flow ratios can fit into any of the above categories but typically replace earnings data with cash flow data. They are useful in situations where the investor is concerned about earnings quality.
• Price multiples are a form of ratio that indicates whether the firm is currently valued relative to peers, the market and its own history.

Activity ratios help investors evaluate a firm’s ability to effectively and efficiently manage its operations and assets. The most commonly used activity ratios include:

• Inventory turnover/Days inventory on hand
• Accounts receivable turnover/Days sales outsanding
• Accounts payable turnover/Days payable
• The cash cycle
• Asset turnover

Inventory management is crucial to the success of a firm. Too much inventory means paying for storage, possible waste or theft, and the opportunity cost that the time and space used to hold onto inventory that remains unsold could have been used instead to buy products that would sell. Having too little inventory, on the other hand, could lead to shortages and possibly missed sales opportunities.

Inventory turnover is an activity ratio that measures the company’s effectiveness by dividing cost of goods sold (an income statement item) by the average inventory balance (a balance sheet item.) Since cost of goods sold represents the inventory that leaves the firm, the ratio allows the investor to see how frequently the company needs to replenish its existing inventory.

As an example, consider the following information from Wal-Mart’s 10K for the fiscal year ended January 31, 2006.

The first thing to recognize is that the income statement represents what happened over the course of the entire year, whereas the balance sheet reflects only a particular date (January 31.) By taking the average of the two year-end numbers we can get an estimate of the typical inventory balance during the year, which is more comparable to the income statement data.

By dividing cost of sales by the average inventory we see that on average Wal-Mart is selling everything it has nearly eight times per year. This number can be tracked over time or compared to other similar companies to see how well the company is managing its inventory. Generally, a higher number is better. However, a number too high might suggest the company is selling merchandise faster than it can be replenished. If a company runs out of a particular item it risks losing sales to a competitor who has the item in stock.

If we divide the inventory turnover into 365 we can estimate how many days worth of inventory is on hand. This ratio, not surprisingly, is called Days Inventory on Hand (often represented as the Simpsons-esque DOH! – which is what management says when the inventory is either too high or too low.)

For Wal-Mart, the days on hand are 365/7.8 = 46.8. In this case, a lower ratio would represent more effective inventory management, all else being equal.

Accounts Receivables Turnover is a close cousin to the Inventory Turnover ratio. It can be used to determine whether the company is having trouble collecting on sales it provided customers on credit.

To compute Accounts receivable turnover, divide sales made on credit by average accounts receivable. Since many companies do not disclose how much of the sales were made on credit, investors often use total sales as a shortcut. When this is done, it is important to remain consistent if the ratio is compared to that of other companies. Comparing one company’s credit-based sales to another’s total sales would be highly misleading.

Let’s look at Plantronics’ data from their 10K for fiscal year 2006 (their fiscal year ends in March.)
Using total sales in the numerator, Plantronics has accounts receivable turnover of 7.3x. Just as with inventory turnover, we can translate this into days by dividing it into 365: 365/7.3 = 50. This number is known as Days Sales Outstanding (DSO.) It represents the average amount of time that elapses after a sale is made before Plantronics collects the proceeds from its customers.

Accounts receivable turnover measures how long it takes for a company to receive payment from its customers for sales made on credit. We can similarly calculate how long it takes for the company to pay its own suppliers for the goods it receives. The resulting activity ratio is called Accounts Payable Turnover.

The formula for accounts payable turnover is to divide purchases made on credit by the average accounts payable balance. As with accounts receivable, companies seldom disclose how much of their purchases were made on credit. Therefore, the usual shortcut made is to assume that all purchases were credit purchases.

Still, there is no single line item that tells how much a company purchased in a year. The cost of goods sold represents what was sold, but the company may have purchased either more or less than it eventually sold. The result would be either an increase or a decrease in inventory.

So, to calculate the purchases made, cost of goods sold is adjusted by the change in inventory as follows:
Purchases = Cost of goods sold + ending inventory – beginning inventory.

Now consider the data for Plantronics, Inc.

Again, as with both the inventory and accounts receivable turnover ratios, this can be expressed in terms of a number of days by dividing the result into 365: 365/13.6 = 26.8. This number is called the Days Payable and represents the average length of time between the date Plantronics receives inventory from suppliers and when it actually pays the supplier for the merchandise.

Three activity ratios – Days on Hand, Days Sales Outstanding, and Days Payable – can be combined to demonstrate how well a company is managing its cash flow. The resulting statistic, known as the Cash Cycle, is calculated as follows:

DOH + DSO – DP = Cash Cycle.

Conceptually, the Cash Cycle measures a company’s need to finance its purchases, or the length of time between when a company spends money and the time it receives the money from selling the resulting product. Going back to the original ratios:

• DOH measures how much inventory the company needs to have in order not to run out and miss sales. In other words, it is how long it will take to sell a particular item after receiving it.
• Days payable measures how much time elapses between receiving the inventory and paying the supplier. So even though the company already possesses the inventory, it doesn’t have to pay for it immediately and this line is therefore a subtraction from the cash cycle.
• DSO measures the time after the sale that the company allows its customers to pay.

In our earlier posts, we calculated the DSO and DP for Plantronics, Inc. as 50.0 and 26.8, respectively. We can also use the information provided to calculate their DOH at 71.5 days. So the cash cycle = 71.5 + 50.0 – 26.8 = 94.7 days.

So, Plantronics needs to get a component 71.5 days before it will actually sell the resulting headset. The first 26.8 days of that time, it will not yet have paid its suppliers. But that leaves 44.7 days (71.5 – 26.8) that it will have to hold inventory that has already been paid for but that has not yet been sold. Then, after making the sale it will have to wait another 50 days before it can collect the cash from its own customers. The total is 94.7 days that the company must be able to operate without the cash its operations will eventually generate.

Working capital items such as inventory, accounts receivable and accounts payable represent the day-to-day financing requirements a company faces. Without inventory there can be no sales, etc. Most of the activity ratios focus on these working capital needs.

However, simply having working capital is not enough. Wal Mart could have all the inventory in the world, but without the store to put it in it would still have no business. Although the store does not constantly have to be replaced, it is essential to conducting business and requires ongoing support in the form of renovation, repairs, etc.

The final activity ratios measure how efficiently a company puts these longer-term assets to use. In other words, how much sales can the company generate given a certain amount of assets in place. The resulting ratio, asset turnover, can be expressed using solely long-term assets or by using total assets. The latter measure incorporates working capital efficiency as well. In either case, the numerator is sales and the denominator is the average asset value (long-term or total) during the period being measured.

Below is the data used to calculate both long-term asset turnover and total asset turnover for Plantronics, Inc.

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Liquidity ratios help investors determine whether a company can pay its bills from day to day. These ratios can be especially useful when looking at small high-tech companies or companies in distress. For high-tech companies, it may be some time before their ideas become commercially viable so it is important to know if the bills are covered in the meantime. For distressed companies, their long-term future may be in doubt and even short-term investors may have concerns.

The three main liquidity ratios are:

• The current ratio.
• The quick ratio.
• The defensive interval.

The cash ratio is a liquidity ratio that tells investors whether a company’s near-term assets are sufficient to cover its near-term liabilities. It is measured as Current Assets/Current liabilities. Using Plantronics as an example, at the end of 2006:

This indicates that Plantronics has more than sufficient current assets to meet its current liabilities.