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Category Archives: working capital
Looking at inventory (II): figuring operating leverage
Analysts get information from company financials by comparing two or more sets
Even if a company’s financial statements have an almost photographic fidelity to the structure and inner workings of the enterprise they represent, it’s very difficult for the outside observer to understand what is being portrayed from one set of financials alone–unless, of course, the company is in disastrous financial shape.
Instead, the analyst gets his information from comparison of two or more sets of financials, preferably covering relatively short periods of time, with one another. In many ways, sequential quarters are the best, since there is the smallest lapse of time between the observation points. For companies with significant seasonality in their product mix, however, comparison of year over year quarters will produce the fewest distortions.
Question #1: is there leverage?
One of the first and most basic question you should ask yourself about a company you are starting to look at is whether it has either financial or operating leverage. A company with leverage is one where a change in revenue produces disproportionately large changes in operating income. Leverage comes in two types:
–Financial leverage comes from a company’s capital structure. The idea is that a company that uses debt to finance expansion will produce higher returns on equity as long as the operating profits produced by expansion are higher than the interest expense on the borrowings.
You can do the calculations yourself, but publications like Value Line have statistical arrays that do the work for you. Look at the lines for “Return on Capital” and “Return on Equity.” If the numbers are different, the company has financial leverage. Hopefully the returns on equity are higher than the returns on capital (debt + equity). That’s the way it’s supposed to work.
–Operating leverage, which comes from the operating structure of the company. Firms with operating leverage typically have high fixed expenses of maintaining a manufacturing (or service) operation, but low variable costs of making each unit sold.
FIFO companies
For a company that uses FIFO accounting (see the first post in this series), finding out the operating profit on an incremental unit of production is easy.
1. Take the revenue figure for the more recent of the quarter you’re comparing and subtract from it the revenue for the more distant quarter in time. That gives you incremental revenue.
2. Do the same for the two operating income figures. That gives you incremental income.
3. Divide incremental income by incremental revenue and you get an incremental margin.
4. Compare this figure with the operating margin for either of the two comparison quarters. If the incremental margin is larger than the average margin for the quarters, the firm in question has operating leverage. And, if so, you know that in forecasting future quarters, incremental revenue will earn the incremental profit margin. Therefore, even small increases in revenue can produce positive earnings surprises. Conversely, even small revenue shortfalls can produce earnigs disappointments.
LIFO companies
For a company that uses LIFO, however, the situation isn’t as straightforward. Under LIFO accounting, every quarter after the first can be a kind of mid-course correction to the estimates the company employed in arriving at first-quarter cost of goods.
I think it’s reasonable to assume that a company uses a consistent estimating methodology from one year to the next. If the company chose last year to add in a little safety margin for earnings later in the year by making a high initial estimate for cost of goods, then it’s a good bet that they’ll do the same for this year.
Therefore, it’s a pretty safe assumption that we can analyze incremental margins using the first quarters of two consecutive years. In any event, it’s the best we can do.
On the other hand, we take a real risk if we use second through fourth quarters by themselves in a year on year comparison. We can’t rule out the possibility that they’re just residuals left from the re-estimating process. But we can use (Q1 + Q2) of the current year vs (Q1 + Q2) of last year to do the incremental calculation described in the FIFO section above. Similarly, we can use Q1 + Q2 + Q3 or the full year as our comparison base.
For the same reason we should hesitate to use Q2, Q3 or Q4 alone, we also probably shouldn’t use sequential quarters to do the calculation.
For a professional securities analyst, it may make sense to do quarterly year on year or sequential comparisons for a LIFO company anyway. If you look at enough years, you may find that there’s a consistent pattern to the LIFO adjustments, so you can anticipate with the company is likely to do in the coming quarters. Even if there isn’t, you may learn enough to make this a topic of conversation with the company’s management. If someone is willing to take the time to explain how they approach LIFO estimates, you’ll doubtless learn a lot of things from the explanation that you’d never have thought about otherwise.
Looking at Inventory (I): general
Two posts
I’m going to cover this topic in two posts. This one will be about what inventories are: the sub-categories of the inventory entry on the balance sheet, and three main ways companies choose to account for inventories. Tomorrow’s post will cover what kinds of information you can get about a company from comparing the inventory entries from different time periods.
Here goes:
There are three sub-categories of inventory on a company’s balance sheet:
–raw materials. This is pretty straightforward. Raw materials are inputs to production that the company owns but has not yet begun to process. They might be a pile of iron ore outside a steel mill or a bunch of windshield wipers stacked in a warehouse next to an auto assembly plant.
This entry records what the company owns, which may be something very different from what’s at the production site. The idea of “just in time” manufacturing is that the component suppliers have warehouses full of their wares that they deliver on the day they’re needed.
In today’s world, financing cost aren’t the big issue. Instead, it’s who takes the risk that the stuff in the warehouse falls in price while it’s just sitting there. The answer is whichever party has less market power, typically the component supplier.
–work in process (which a lot of people incorrectly call “work in progress”). This is stuff that has entered production and is in the process of being turned into finished goods. The increase in value of the raw materials will be a mix of direct costs involved in making the item, like salaries of assembly workers, and indirect, or period costs, like the cost of renting/leasing the production site, utilities (heating, lighting), and salaries of foremen and the plant manager.
The amount of work in process varies widely from industry to industry. Assembly of a PC or a cellphone may take a day. A semiconductor may take several months. Wine or whiskey may ferment for years.
–finished goods. This one is also straightforward. It’s the final products a company makes that are waiting in storage for a buyer to pick them up–or in some cases, to materialize in the first place.
How finished goods move from the balance sheet to the income statement Continue reading
Working Capital: cash and short-term investments
Many observers have remarked that accounting techniques can give favorable shadings to almost every balance sheet or income statement entry–but they can’t do anything about cash. Therefore, they conclude, analyze the changes in cash and you can most accurately assess the strategy a company is taking and the profits a company is making.
Analyzing cash as a component of working capital
I think this is right, but analyzing cash–which means looking at the sources and uses of funds–is a little more complex than just looking at the “cash” item in Current Assets. For working capital purposes, though, there are only a few things to look for to make sure you get an accurate picture of the changes, + or -, in the cash a company is holding:
Three rules
1. Count all the cash. Cash in a checking account (cash) and T-bills (short-term investments) will certainly appear in Current Assets. But if the company has cash it knows it won’t need for a while, it may also buy Treasury securities that mature in more than twelve months. They’ll be in the long-term section of the balance sheet, as Long-Term Investments. Count them, too (you may have to check the footnotes to the balance sheet to make sure the company hasn’t mixed in equity holdings in joint venture projects, or other “real” investments that shouldn’t be counted as cash.).
2. Look for a buildup in financial liabilities and subtract it, if there is one. Check for increases in payables and short-term debt and long-term debt. Also make sure there hasn’t been an equity issue. All of these items will generate cash, but adding liquidity from new debt or new equity isn’t the same as adding it from operations. It’s highly unusual for a company to issue a special cash dividend to use up extra cash (WYNN is the only firm I’m aware of to do so recently), but you might look for that and add it back in. Personally, I wouldn’t add back in stock repurchases, although firms present these as a “return” of cash to shareholders, since they typically only offset (as well as disguise) the company’s issuance of stock to top management.
3. Think twice about negative working capital companies. When negative working capital companies have increasing sales, they generate excess cash, just due to the fact that customers pay for the product/service either in advance or before the company has to pay its suppliers. Often, these companies will use the excess cash to fund capital expenditures, believing that they will continue to grow and generate larger amounts of cash. That’s the highest probability case. But there’s always the risk that revenues will stagnate, or even begin to decline–in which case the business will begin to absorb cash rather than throw it off. One adjustment for the cash position of negative working capital companies would be to calculate payables minus receivables and subtract the difference from cash.
Working Capital: inventory
Inventory
Inventories are either a very complex topic or a very simple one. I’m taking the simple route here.
One ratio: inventory/sales (or sales/inventory)
There’s only one ratio that securities analysts are interested in: inventory/sales. As with other working capital items, one could also calculate inventories/cost of goods, but I don’t think that using this less common ration gets materially different results.
What the ratio means
The significance of the ratio is what one would expect–it’s bad if the ratio of inventory/sales starts to go up vs. historical experience.
Two cases
In looking at inventories, it’s important to distinguish two cases: manufacturing companies, which create products or services, and distribution companies, which add their value by selecting among products of manufacturers and making them available either to other distributors or to end-user customers.
1. Manufacturing companies. For a manufacturer, inventory is classified into three categories:
–raw materials,
–work in process, and
–finished goods.
You’ll probably be able to get additional information from examining the percentage of total inventory contained in each category, but normally looking at the overall inventory total will be good enough.
A rise in the inventory/sales ratio usually represents an unanticipated slackening in demand for products contained in the finished goods inventory. The falloff can be the result of a general economic slowdown, the emergence of new competition, or something wrong with the product itself.
(Note: while an unintended rise in inventories is a bad thing, a 15% rise in the dollar amount of finished goods doesn’t mean there are 20% more items in the company’s warehouses. For example, assume the company has factory costs of $1 million a quarter that it allocates over full-capacity production of 1 million units. That amounts to $1 per unit. If the variable costs for each unit are $1, then the total cost per unit will be $2. If nothing is sold during the quarter, the total dollar amount added to inventory will be $2 million.
If the beginning inventory is 5 million units and $10 million, then the ending inventory is 6 million units and $12 million.
Now suppose instead that the company responds to order cancellations by cutting current-quarter production in half. That means it makes 500,000 items at a variable cost of $1 each. It allocates $1 million of factory costs of those items at a rate of $2 each. So total cost per unit is $ 3. Ending inventory is 5.5 million units and $11.5 million in value. In this case, the dollar value of inventory has gone up by 15%, but total units are only up by 10%.)
2. Distribution companies (think: Amazon, Advance Auto Parts or a supermarket). Distributors are typically low-margin, high inventory turnover businesses. They may have considerable value imbedded in their brand names, the know-how that produces their logistics computer systems and their physical store locations. But these positive attributes do not often manifest themselves in high operating margins. As a result, because they do not have the high margins of companies with significant legally-protected intellectual property, some growth investors tend to underestimate their earnings expansion potential.
Distributors’ claim to fame rests in their ability to turn inventories quickly. For this reason, analysts usually place a lot of their analytic efforts on inventories, which they talk about in terms of “turns,” that is, annual sales divided by average (or some other measure to smooth out seasonal variations) inventories.
Since distribution companies usually don’t have exclusive rights to sell unique products, the sales/inventory ratio–how many times it can “turn” inventories in a year–is a good standard of comparison across competitor distribution companies, as well as for comparing a firm with its own history.
For a strong distribution company, sales should rise faster than inventory. Therefore, inventory turns should rise over time.
Any deterioration of the pattern, either a flattering out of turns or a decrease in turns, is a cause for concern. On the other hand, an increase on turns, or even better, an acceleration of turns, is a very bullish sign.
