Monthly Archives: December 2009
Working Capital: payables
Accounts payable
Accounts payable, or simply payables, are the trade credit that is extended to a company by its suppliers. Payables are liabilities, things the company owes to others. In almost all instances payables are current liabilities, and, as such, part of working capital. There are rare instances, however, where they are long-term liabilities. I gave an example of oilfield service company behavior after the mid-Eighties collapse in energy prices in my post on receivables. The corresponding item to the long-term receivables on the oilfield service balance sheet would be the long-term payables on its customers’.
Two ratios
There are two payables ratios of primary interest to a securities analyst: payables/sales and payables/receivables. Both are calculated using the payables and receivables figures taken from the balance sheet of a certain date. The sales figure used is for the twelve months ending on the balance sheet date.
The ratios are compared, first and foremost, with a company’s own history. But since a supplier normally provides customers with more or less standard raw materials on more or less standard payment terms, it is also reasonable to compare the payables to sales ratios among different firms in a given industry. The results will give a first approximation for the relative market strength and relative bargaining power of industry participants.
1. receivables/payables. Receivables/payables is a way of quantifying the relative strength of a company vs. suppliers and customers in the universe it operates in. In a CEO’s ideal world, customers would be so eager for the company’s products that they would pay in cash–or even in advance (therefore, no receivables)–and suppliers vying for the privilege of supplying the company would provide unusually long payment terms (big payables). In CEO hell, on the other hand, suppliers would be so worried about the financial viability of the company that they would demand payment up front (therefore, no payables) and customers would take the finished product only if they could obtain (a la Chrysler) unusually generous financing (big receivables).
As a general rule, the bigger the number, the weaker the position of the company in question. It’s also important to examine the historical record. Is this ratio constant over time, or has it recently begun to signal strength or weakness?
Look at the raw numbers, too
In addition to looking at the ratio, you should look at the raw numbers as well–and in two ways. First, consider how much of the overall credit extended to customers by a company is in effect being financed by credit it is receiving from suppliers. Then look at the increase in receivables over the previous, say, three years and compare that with the increase in payables. Do the competitive dynamics of the company’s industry allow the company to keep any of the benefit of increased credit from suppliers? or has the company been forced to simply pass this financing benefit on to customers?
2. payables/sales Decline in this ratio can be a very important early warning sign of impending trouble for a company. Suppliers are constantly analyzing the prospects of all their customers. Because they deal with a wide variety of firms in their targeted industries, and because they see the pattern of their customers’ payments for supplies, they possess a very sophisticated picture of the industry and each company’s place in it.
Trade creditors are also at the bottom of the pile when it comes to recovery during liquidation. So they have a lot to lose if they continue to send materials to a failing customer. As a result, shrinkage in payables is a very reliable indicator of potential trouble.
Working Capital: receivables
What receivables are
When a company performs a service or ships a product to a customer, it also submits a bill or invoice. The amount of time the customer has before payment of the invoice is due varies from industry to industry. Payment terms can also change, based on negotiation between the parties involved. Terms can also include a discount for early payment or penalties for late payment.
The total of all of a company’s not-yet-paid invoices is listed on the asset side of the balance sheet as Accounts Receivable. Except under the most unusual circumstances (see below), receivables are listed as Current Assets. They are a key component of working capital.
How analysts look at receivables: receivables/sales
A securities analyst most often begins to look at receivables by calculating a receivables/sales ratio for different time periods:
–that is, the ratio of outstanding receivables at a specific balance sheet date to total sales for the twelve months ending with the balance sheet date.
The analyst then looks for any pattern or trend that may appear in the ratio over the past few years. For an industry with distinct seasonal variation in sales and receivables (think: toys or jewelry), the best comparison to consider when inspecting for trends is year over year. For those without seasonality, quarter on quarter comparison may be equally good.
(An aside: Some people prefer to look at receivables/cost of goods. I’ve never quite gotten why, and in my experience you don’t get materially different results, but I suppose it shifts emphasis to seeing how long it takes a firm to recover its cash outlays rather than making a profit.)
Note, too, that receivables are customarily listed net of (i.e., after deduction of) an allowance for doubtful accounts. That’s a provision, based on the company’s historical experience, for receivables that will probably never be paid. Apple, for example, lists $3,361 million in receivables on its 9/26/09 balance sheet. That’s after a $52 million doubtful accounts allowance. I suppose you could analyze the doubtful accounts provision for patterns. I’ve never done it, so I don’t know what you’d find. But since the allowance gradually adjusts, based on recent deviations from past experience, my guess is that this would be a lagging indicator.
The ratio’s significance
Why is the receivables/sales ratio important? Assuming no changes in the company’s business lines, receivables/sales should be relatively stable. If the ratio begins to deteriorate–that is, if the number gets bigger–it can be one of the earliest signs of weakening in a company’s business. Of course, it’s not the only sign. If the company is having trouble, there will likely also be indications in the behavior of inventories (they get bigger) and payables (they get smaller). But receivables/sales is very reliable.
The general idea is that the credit terms offered to customers are one of a collection of factors that influence a customer to choose one company’s products over another’s. It’s one of the easiest factors to alter for a firm chasing a reluctant buyer. A rising receivables/sales ratio is balance sheet evidence that the company is either offering extended payment terms to current credit customers or offering credit to customers who previously were asked to pay cash. It is presumably doing this to win sales it would not get otherwise. In other words, demand for its products is less than it has previously been.
One may also try to compare receivables/sales across different companies in the same industry. In theory, the ratio should be the lowest in the strongest companies and highest in the weakest. The practical difficulty is in finding companies with similar enough business mixes for the comparison to be valid. For instance, even a relatively simple business that sells mostly at wholesale would have a different receivables pattern than one in the same industry that sells mostly at retail.
Examples
You may remember that Mitsubishi Motors had a sales campaign several years ago that offered liberal financing, featuring:
–zero down payment
–zero interest rate, and
–zero payments for one year.
It did a ton of financing and sold a ton of cars. But it found out, starting about a year later, that almost zero people intended to make any payments on these loans. (Yes, I’m sure this financing was done off-balance sheet. My point is that having to offer sweetened financing terms is virtually always a sign of trouble.)
Similarly, as I’ve mentioned in another post, when Chrysler was going through bankruptcy, it came to light that a third of its customers were sub-prime credits who were buying Chryslers because no one else would lend them money to buy their cars.
Quirks to be aware of
1. Companies sometimes factor receivables, i.e. sell them to third parties, to get them off the balance sheet. If so, this fact will be disclosed in the Notes to Consolidated Financial Statements, either in the Accounts Receivable footnote or in the first footnote–Summary of significant accounting principles. Factoring receivables, even if it’s done to make the balance sheet look better than it would otherwise, may be a relatively benign thing. If a company is really having difficulties, counterparties will quickly work this out and decline to purchase further receivables.
2. The customary format for the physical layout of the balance sheet is to have current items listed at the top, with long-term items below them. Occasionally, you will see some receivables listed as long-term items–indicating payment is not due for at least a year. Sometimes, these can be innocuous entries that mirror the terms of a multi-year contract.
In other cases, however, this can be an attempt by a troubled company to divert attention from its financial/operating difficulties. In the early Eighties, during the oilfield slump following the second “oil shock” of the Seventies, I was an oil analyst. I saw oilfield service companies that had bloated inventories of the steel pipe (used to line the sides of oil/gas wells) that were starting to rust in their distribution yards. Some told their customers, in effect–please take as much pipe as you can and pay us when you’re able. To the extent that customers did, that shifted the (worthless) inventory out of current assets and into (worthless) long-term receivables.
This was, of course, only a cosmetic alteration. But it may have made the company managements feel better. And it may have fooled some careless investors.
Working Capital: general
Working capital
This is the first in a series of posts about the elements that go into working capital.
An analysis of working capital can quickly produce important insights into the state of a company’s business. So it’s an extremely important topic for any securities analyst. Yet it’s my feeling that working capital analysis is often skipped over, even by professionals, although it doesn’t take much time to become proficient at reading what this part of the balance sheet has to tell you.
What it is
What is working capital? It’s total current assets minus total current liabilities. “Current” here means balance sheet items that record and trace the progress of the cash conversion cycle. For most companies, this cycle covers a period of a few months. For such companies, simply as a convention, “current” is defined as items that will be used, or used up, in a twelve-month period. For companies with a longer cash conversion cycle, say, a distiller who specializes in making ten year-old scotch, current means however many years it takes from the purchase of raw materials to the sale of the finished product.
‘Current” is also as opposed to “long term,” the latter meaning permanent or semi-permanent assets (like real estate, factories, trademarks) and liabilities (like a twenty-year debenture or preferred stock or common equity).
Cash conversion
The cash conversion cycle? That’s the sequence of events that starts with cash being used to purchase raw materials, sometimes on credit, which are then turned into work-in-process and then finished goods. The finished goods are sold on to customers, who are perhaps extended credit but who will at some point pay for the merchandise. This allows the company to pay for the raw materials and have its original cash plus profits back in its hands. In the cycle, then, you start with cash and end with cash.
One of the original rules formulated by Benjamin Graham (1894-1976), who is thought of as the father of modern securities analysis, was to buy stock in a company when it was trading at 50% of net working capital (meaning current assets minus current liabilities minus long-term debt) or below and sell it when it rose to 100% of net working capital. The idea was that if the company just stopped making anything, sell its remaining inventories and collect the accounts receivable (trade credit given to customers), the cash on the balance sheet would be enough to pay off all the company’s debt and have 2x the stock price per share in cash + all the factories, machinery, real estate, etc. left over.
Stocks that meet this strict criterion may have been plentiful during the great depression of the Thirties, but other than at moments of extreme panic at market lows, they’ve been few and far between over the past thirty years. Still, the general idea is a good one–and I’m confident, though I haven’t looked, that one could have found firms trading at 100% of net working capital just this past March.
Working capital isn’t always good
Everything I’ve written so far makes the tacit assumption that having working capital is a good thing. That’s not always the case, though. For example:
1. When I first looked at Mizuno (Japan) as a stock, I was struck by the fact that the stock was trading at a discount to its working capital, even in a buoyant (second half of the Eighties) stock market. On Ben Graham principles, the stock looked like a bargain. But it wasn’t. How so? In order to get retailers to stock its sports merchandise, Mizuno had to offer financing of what looked to me to be about two years! Most of its working capital was money tied up in trade receivables. In this case, the fact of huge working capital was a real sign of weakness. And it had to be financed through large dollops of long-term debt.
2. There are very valuable businesses, like restaurants, hotels, magazine publishers (in a better age) or public utilities, that typically have negative working capital. In all these cases, customers either pay for services in advance–magazine subscriptions and public utilities, or they pay as the services are delivered–restaurants and hotels–but the company pays for food, rent, labor at the end of the month, i.e. on average two weeks after it collects its money.
So long as these businesses are growing, they generate increasing amounts of cash that’s not needed to pay bills. In the public utility case, this extra cash may amount to three months’ sales; in the restaurant case, it’s more like two weeks’ sales.
That’s it for now. Succeeding posts will deal with the key individual elements of working capital, like receivables, inventories, payables, and how to analyze them.
Project accounting–production accounting
“Normal” accounting
Accounting statements typically measure the success (or lack of it) of geographical or functional units of a company. The measurement is also usually organized through units of time, such as a fiscal quarter or a fiscal year. So the accounting statements answer questions like “What were the profits of the Americas division for the third quarter?” or “What were the profits of the plate glass business last year?”
Project accounting
One notable exception to this rule is project accounting, which is designed to measure the economic performance of a specific task. The task is typically relatively large and takes place over an extended period of time. Examples include: public works construction projects; government research and procurement, like work done under national defense contracts; and movies.
What characterizes this type of accounting, from an investor’s point of view, is the necessity for estimating revenues, costs or both over a multi-year period. In the best of cases, this is a difficult task. At worst, it gives great scope for a company to delude itself about the profits it is making. And it leaves the door open to the possibility of fraud, through deliberately inflated revenue/cost estimates, which will likely not be detected until the project is finally completed.
A construction project
Here’s an example:
Let’s say a company wins in competitive bidding a contract for $1 billion to build a dam. Construction will take two years. It’s a fixed-price contract, meaning that the government body that has awarded the contract will make no adjustment to the contract amount for things like changes in materials or labor costs.
Our company has estimated that it will cost it $850 million to build the dam, so that it will have profits of $150 million and an operating profit margin of 15%. How does it record on its financial statements the money it is earning on the project?
The usual method companies use is percentage of completion, meaning that from its project estimates it determines what constitutes 10% of the job, what constitutes 20%, and so on. If, in a given quarter, it believes it has accomplished 10% of the job, it will report $100 million as revenue, $85 million as cost and $15 million as operating profit.
(Note: The government body will have a parallel process for determining the progress of the project. It will set milestones whose achievement trigger progress payments to the company from the $1 billion. The sequence of these payments may be very different from what our company records on its income statement. For example, the government body may make an initial payment of $100 million before any work is done. Such differences are reconciled through entries on the balance sheet. In this case, our company would enter $100 million in deferred revenues on the balance sheet.)
Typically a company will stick with its estimate unless there is overwhelming evidence that it has been too optimistic. It’s usually very difficult for even professional investors to have any real sense that this may be happening, because projects are normally very complex with very long lives. We also don’t often get to see the company’s project estimates in any detail. So we may well get into the final quarter of year two, when the company has already booked $130 million in profit, only to learn that the area where the dam is not as geologically stable as the company thought and it has to spend $50 million more than anticipated to reinforce the structure of the dam. What results from this? a big writedown!
Early completion bonuses, late delivery penalties
It can also happen that the contract has provisions for a sizable bonus for early completion of the work, as well as hefty penalties for late completion. No one that I’m aware of will factor the bonus into its estimates. But neither will anyone plan on paying late-completion penalties. But in construction it does happen that the company says the project is coming in on time until the very last minute, when it reveals a delay. The result?…another writedown.
In sum, the issues with project accounting for an investor are that the project is hard to monitor form the outside, and that there’s always the potential for an ugly negative surprise at the end.
Movie production accounting
One special instance of project accounting worth mentioning is movie production accounting. The principles are the same, but –unlike the construction company that knew its revenue for certain but not its costs–in this case the key estimate the movie studio makes is what total revenue from a given film will be. It knows pretty accurately what its costs have been. (Note: movie accounting is as arcane, convoluted and jargon-filled as anything I’ve ever seen–even oil and gas accounting. So my last sentence is a real simplification.)
From its revenue estimate, the studio gets a total operating profit estimate and an operating margin. If it thinks it will get total revenue of $500 million from the film and $100 million comes in during the period, it will record that figure, deduct 20% of the movie’s cost, and get an operating profit.
The big current issue with movie accounting (the perennial issues are its opacity and perceived tendency to favor insiders) is that movie revenue comes from many sources, among them: theatrical release, which may occur at different times in different countries; DVDs; video on demand; and TV rights.
Until the financial crisis, a good guess would be that DVD would account for at least half of a hit film’s revenues and be as much as 1.5x the size of the money a studio would earn from showing it in theaters. But in the past two years or so, people have stopped buying DVDs. And, as luck would have it, DVD revenue comes toward the tail end of the project. So studio estimates for the profit of movie projects which have been started between 2007 and relatively recently are probably way too high. Hence the rash of writedowns we are starting to see from movie companies.
Conclusion
Although I’ve concentrated on the uncertainties surrounding project accounting, I don’t want to say it’s a totally bad thing. In the final analysis, even though the project accounting technique presents managements with more than the usual number of chances to hope against hope, the accounting uncertainties reflect the uncertainties inherent in taking on multi-year projects and making multi-year revenue and cost estimates.
Nevertheless, these uncertainties typically mean the companies in these industries trade at lower price-earnings multiples than those in other industries.