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.

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.