Archive for the 'Ratio Analysis' Category

Asset Turnover

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.

2006 2005

Current assets

Non-current assets 283,900 81,235
Total assets

Sales/Average non-current assets 4.11
Sales/Average total assets 1.36

Posted on 19th April 2008
Under: Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Adjusted Earnings Yield

The earnings yield is a company’s earnings per share divided by its price per share. Earnings yield has frequently been used to predict real return for stocks. Since earnings are not reported on a real basis, Stephen Wilcox presented a technique in the September/October 2007 Financial Analysts Journal to adjust earnings yield to better represent real return. Statistical tests show that this measure better predicts future real returns than other popular valuation measures.

There are two primary adjustments considered:

  • An accounting adjustment to convert historical cost measures to current value
  • An adjustment to liabilities to reflect the real cost of capital as principal values erode due to inflation

Posted on 12th March 2008
Under: Fundamental Analysis, Investing in Stocks, Investment Returns, Ratio Analysis, Research, Valuation | No Comments »

Price/Book, Operating Leverage and Market Returns

It is generally accepted in corporate finance that higher levels of operating risk (operating leverage) and higher use of leverage (financial risk) will increase equity risk and thus investors will require a higher return from the stock.

In the May 2007 Journal of Accounting Research, Penman, Richardson and Tuna examine the positive relationship between the book/price ratio and subsequent stock market returns by separating book/price into operating leverage and financial leverage effects.

The authors define “enterprise book-to-price” as the net operating assets divided by market price and use it as a proxy for operating risk. Leverage is net debt divided by the market value of equity.  They find that operating leverage does has a positive relationship to subsequent stock returns, but that financial leverage has a negative relationship.

Posted on 11th January 2008
Under: Investing in Stocks, Portfolio Management, Ratio Analysis, Research | No Comments »

Using Revenue and the Balance Sheet to Derive Cash Collected From Customers

The “top line” revenue number is of particular significance in financial statement analysis. For one thing, overstating the revenue line will generally have a direct impact on profits. A relatively easy way to assess the earnings quality of revenue is to convert it into cash collections from customers, as would be done when creating a direct-method statement of cash flows.

Under normal circumstances, revenue and cash collections from customers should follow a similar pattern. By analyzing the ratio of revenue to cash collection over time, investors may be able to detect changes in the quality of sales. The conversion itself is fairly simple: Cash collections from customers = Revenue – the change in accounts receivable + any change in deferred revenue.

It is useful to check the footnotes to the financial statements, as deferred revenue and certain receivables are frequently lumped into “other” liabilities and assets, respectively. It would also be prudent to adjust receivables for any changes in the amount of securitized, or “factored” receivables.

Posted on 2nd November 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

Bill and Hold Sales

In a document titled “Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002,” the U.S. Securities and Exchange Commission noted that:

Improper accounting for bill-and-hold transactions usually involves the recording of revenue from a sale, even though the customer has not taken title of the product and assumed the risks and rewards of ownership of the products specified in the customer’s purchase order or sales agreement. In a typical bill-and-hold transaction, the seller does not ship the product or ships it to a delivery site other than the customer’s site. These transactions may be recognized legitimately under GAAP when special criteria are met, including being done pursuant to the buyer’s request.

By booking revenue before the customer has accepted delivery of the goods or services in question, a company recognizes revenue earlier than it otherwise would. To the extent that investors expect the company to earn a certain level of revenue in a period, or to the extent that salespeople are compensated based on target sales levels, this accounting practice is considered aggressive.

Ways to identify potentially aggressive revenue recognition include monitoring the relationships between sales and accounts receivable, and sales and deferred revenue or income. Significant variations in these ratios may be a signal that the company’s revenue recognition practices may be changing over time.

Posted on 2nd October 2007
Under: Accounting, Adjusting Reported Financial Statements, Analyzing Press Releases, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

The 3-Stage DuPont Model

Return on equity is one of the most significant financial ratios. Not only does it describe how well management is making use of the funds it has been entrusted with, but it also sets the limits of sustainable growth. Analysts at DuPont created a system to analyze the components of ROE to better understand how the return is being generated.

The basic formula for ROE is net income divided by shareholders equity. This, in turn, can be recast into two components – the return on assets and the impact of leverage.

(Net income/Shareholders equity) = (Net income)/(Total Assets) X (Total assets)/(Shareholders equity).

ROA can also be expressed as a function of profit margin and asset turnover: (Net income)/(Total assets) = (Net income)/Sales X Sales/(Total assets) and thus ROE = (Net income)/Sales X Sales/(Total assets) X (Total assets)/(Shareholders equity).

Posted on 19th September 2007
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Accounting for Foreign Currency Transactions

When companies using different currencies transact business, at least one of the companies will have to translate a foreign currency into its home currency. For sales made in cash, this can be done at the time of sale.

When the sale is made on credit, the company will have to record an account receivable or account payable until the account is settled. During the interim, the relative values of the currencies could change. The accounting treatment for such changes is governed by International Accounting Standard (IAS) 21 and U.S. Financial Accounting Standard (FAS) 52. The treatment is the same under either method.

  • At the time of sale, the sale is recorded at the current exchange rate and an equivalent value asset or liability is created.
  • If balance sheets are prepared prior to collection, the asset or liability must be restated to the then-current exchange rate value. The change is recognized as an unrealized exchange rate gain/loss on the income statement.
  • When the account is collected, the asset or liability is removed and any previously unrecognized gain/loss is recognized on the income statement.

Since the asset and liability are always presented at fair value and changes flow through the income statement, there is seldom need to adjust the financial statements to examine the effect.

Posted on 19th September 2007
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Inventory Accounting: Differences Between U.S. GAAP and International Standards

U. S. GAAP considers inventory cost at the time it was placed in inventory, whereas International Accounting Standards base the cost on the order in which the products are sold. When possible, international standards prefer that the specific identification method be used.

When it is not practical to track inventory costs on a unit basis, international standards permit either the first-in, first-out (FIFO) method or the weighted average cost method. Lifo is not permitted, as it is under U.S. standards. Fortunately, U.S. standards require companies using LIFO to report the FIFO inventory value, and thus it is generally possible to adjust the U.S. financial statements for comparability with firms that do not use LIFO.

Both standards require inventory to be stated at the lower of cost or market value, and inventory that has declined in value must be written down. Under U.S. standards these writedowns cannot be reversed even if the inventory subsequently rises in value. International standards do permit reversal of inventory writedowns.

Posted on 12th September 2007
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Growth Investment Styles

Growth investors are typically willing to pay higher valuations (P/E ratios) for stocks that have high earnings growth, in the expectation that the growth will allow the earnings to “catch up” to the valuation. However, if growth does not materialize the valuation typically declines as well, resulting in more substantial losses.

Growth investors may seek consistent growth or earnings momentum. Consistent growers have a long history of sales growth, high profitability and predictable earnings. Stocks have earnings momentum when the year/year increase is very large and, preferably, the growth rate itself is increasing. Earnings for such companies are usually less predictable, and the growth rate itself is less sustainable. As a result, such strategies tend to have relatively short holding periods.
Source: Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

Posted on 16th August 2007
Under: Asset Allocation, FInancial Planning, Investing in Stocks, Investment Returns, Portfolio Management, Ratio Analysis, Valuation | No Comments »

How Lessors Report Operating Leases

When a lease is classified as an operating lease, the related assets and liabilities are kept off of the lessee’s balance sheet. Logically, this means that they remain on the lessor’s balance sheet. The lessor’s balance sheet will show the asset, and depreciation of the asset will be counted as an expense on the income statement and reduce the carrying value of the asset.

The lessor will record lease revenue as the lease payments are received.

Posted on 12th August 2007
Under: Accounting, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »