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2012-11-02 09:55:27
July 12 2012| Filed Under Accounting, Fundamental Analysis, Investment,
Stocks
Analyzing a company's inventories and receivables is a reliable means of
helping to determine whether it is a good investment play or not. Companies
stay efficient and competitive by keeping inventory levels down and speeding up
collection of what they are owed. In this article, we'll take you through the
process step by step.
Getting Goods off the Shelf
As an investor, you want to know if a company has too much money tied up in its
inventory. Companies have limited funds available to invest in inventory - they
can't stock a lifetime supply of every item. To generate the cash to pay bills
and return a profit, they must sell the merchandise they have purchased from
suppliers. Inventory turnover measures how quickly the company is moving
merchandise through the warehouse to customers.
Let's look at U.S. retail giant Walmart, known for its super-efficient
operations and state-of-the-art supply chain system, which keeps inventories at
a bare minimum. In fiscal 2011, inventory sat on its shelves for an average of
40 days. Like most companies, Walmart doesn't provide inventory turnover
numbers to investors, but they can be flushed out using data from Walmart's
financial statements.
Inventory Days = 365 Days / (Average Cost of Goods Sold/Average Inventory)
Obtaining Average COGS
To get the necessary data, find its Consolidated Statements of Income on the
company's website and locate cost of goods sold (COGS), or "cost of sales"
found just below the top-line sales (revenue). For the 2011 fiscal year,
Walmart's COGS totaled US$315.29 billion.
Obtaining Average Inventory
Then look at the Consolidated Balance Sheet (the next page after Statements of
Income). Under assets, you will find the inventory figure. For 2011, Walmart's
inventory was $36.3 billion, and in 2010, it was $32.7 billion. Average the two
numbers ($36.3 billion + $32.7 billion / 2 = $34.5 billion), then divide that
inventory average, $34.5 billion, into the average cost of goods sold in 2011.
You will arrive at the annual turnover ratio 9.1. Now, divide the number of
days in the year, 365, by the annual turnover ratio, 9.1, and that gives you
40.1. That means it takes Walmart about 40 days, or about a month and a half,
to cycle through its inventory. This number of inventory days is also known as
the "days-to-sell" figure.
Broadly speaking, the smaller number of days, the more efficient a company -
inventory is held for less time and less money is tied up in inventory. Using
the same calculations above, Walmart's numbers back in 2003 yielded 45 days,
which goes to show that within that decade range, the company has increased its
inventory efficiency. Thus, money is freed up for things like research and
development, marketing or even share buybacks and dividend payments. If the
number of days is high, that could mean that sales are poor and inventories are
piling up in warehouses.
Remember, however, that it's not enough to know the number at any specific
time. Investors need to know if the days-to-sell inventory figure is getting
better or worse over several periods. To get a decent sense of the trend,
calculate at least two years' worth of quarterly inventory sales numbers.
If you do spot an obvious trend in the numbers, it's worthwhile asking why.
Investors would be pleased if the number of inventory days were falling because
of greater efficiencies gained through tighter inventory controls. On the other
hand, products may be moving off the shelf more quickly simply because the
company is cutting its prices.
To get an answer, flip to the Income Statement and look at Walmart's gross
margin (top-line revenue, or net sales, minus cost of sales). Check to see
whether gross margins as a percentage of revenue/net sales are on an upward or
downward trajectory. Gross margins, which are consistent or on-the-rise offer
an encouraging sign of improved efficiencies. Shrinking margins, on the other
hand, suggest the company is resorting to price cuts to boost sales. Looking
back at the numbers, you will find that Walmart's gross margins, as expressed
as a percentage of net sales, went down 0.2% from 24.9% in 2010 to 24.7% in
2011 (gross margin = net sales - COGS/net sales).
If inventory days are increasing, that's not necessarily a bad thing. Companies
normally let inventories build up when they are introducing a new product in
the market or ahead of a busy sales period. However, if you don't foresee an
obvious pick-up in demand coming, the increase could mean that unsold goods
will simply collect dust in the stockroom.
Collecting What's Owed - Soon!
Accounts receivable is the money that is currently owed to a company by its
customers. Analyzing the speed at which a company collects what it is owed can
tell you a lot about its financial efficiency. If a company's collection period
is growing longer, it could mean problems ahead. The company may be letting
customers stretch their credit in order to recognize greater top-line sales and
that can spell trouble later on, especially if customers face a cash crunch.
Getting money right away is preferable to waiting for it - especially since
some of what is owed may never be paid. The quicker a company gets its
customers to make payments, the sooner it has cash to pay for salaries,
merchandise and equipment, loans and, best of all, dividends and growth
opportunities.
Therefore, investors should determine how many days, on average, the company
takes to collect its accounts receivable. Here is the formula:
Receivables Days = 365 Days / (Revenues/Average Receivables)
On the top of the Income Statement, you will find revenues. On the Balance
Sheet under current assets, you will find accounts receivable. Walmart
generated $418.9 billion in net sales in 2011. At the end of that year, its
accounts receivable stood at $5 billion, and in 2010, it was $4 billion,
yielding an average accounts receivable figure of about $7 billion.
Dividing revenue by average receivables gives a receivables turnover ratio of
60. This shows how many times the company turned over its receivables in the
annual period. Three hundred and sixty-five days of the year divided by the
receivables turnover ratio of 60 gives a receivables turnover rate of three
days. On average, it took about a week for Walmart to receive payment for the
goods it sold.
Sizing-up Efficiencies
It's good news when you see a shortening of both inventory days and the
collection period. Still, that's not enough to fully understand how a company
is running. To gauge real efficiency, you need to see how the company stacks up
against other players in the industry.
Let's see how Walmart compared in 2003 to Target Stores, another large,
publicly-listed retail chain. Dramatic differences can be seen. While Walmart,
on average, turned over its inventory every 40 days during that period,
Target's inventory turnover took nearly 61 days. Walmart collected payments in
just three days. Meanwhile, Target, which relied heavily on slow-to-collect
credit card revenues, required almost 64 days to get its money. As Walmart
shows, using competitors as a benchmark can enhance investors' sense of a
company's real efficiency.
Still, comparative numbers can be deceiving if investors don't do enough
research. Just because one firm's numbers are lower than a rival's, doesn't
mean that one firm will have a more efficient performance. Business models and
product mix need to be taken into account. Inventory cycles differ from
industry to industry.
Keep in mind that these efficiency measures apply largely to companies that
make or sell goods. Software companies and firms that sell intellectual
property as well as many service companies do not carry inventory as part of
their day-to-day business, so the inventory days' metric is of little value
when analyzing these kinds of companies. However, you can certainly use the
days' receivables formula to examine how efficiently these companies collect
what's owed.
The Bottom Line
Finding out where a firm's cash is tied up in inventories and receivables can
help shed light on its how efficiently it is being managed. Of course, it takes
time and effort to extract the information from company financial statements.
However, doing the analysis will certainly help you find which companies are
worthy of investment.
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Ben is the director of Bay of Thermi Limited, an independent research and
consulting firm that specializes in preparing early stage ventures for new
investment and the marketplace. He works with a wide range of clients in the
North America, Europe and Latin America. Ben was a highly-rated European
equities analyst at London-based Old Mutual Securities, and led new venture
development at a major technology commercialization consulting group in Canada.
He started his career as writer/analyst at the Economist Group. Mr. McClure
graduated from the University of Alberta's School of Business with an MBA.
Ben's hard and fast investing philosophy is that the herd is always wrong, but
heck, if it pays, there's nothing wrong with being a sheep.
He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi
Limited at www.bayofthermi.com.