2011-07-29 09:10:16
For stock investors, the balance sheet is an important consideration for
investing in a company because it is a reflection of what the company owns and
owes. The strength of a company's balance sheet can be evaluated by three broad
categories of investment-quality measurements: working capital adequacy, asset
performance and capitalization structure.
Tutorial: Financial Statement AnalysisIn this article, we'll look at four
evaluative perspectives on a company's asset performance: (1) the cash
conversion cycle, (2) the fixed asset turnover ratio, (3) the return on assets
ratio and (4) the impact of intangible assets.
The Cash Conversion Cycle (CCC)
The cash conversion cycle is a key indicator of the adequacy of a company's
working capital position. In addition, the CCC is equally important as the
measurement of a company's ability to efficiently manage two of its most
important assets - accounts receivable and inventory.
Calculated in days, the CCC reflects the time required to collect on sales and
the time it takes to turn over inventory. The shorter this cycle is, the
better. Cash is king, and smart managers know that fast-moving working capital
is more profitable than tying up unproductive working capital in assets.
CCC = DIO + DSO DPO
DIO - Days Inventory Outstanding
DSO - Days Sales Outstanding
DPO - Days Payable Outstanding
There is no single optimal metric for the CCC, which is also referred to as a
company's operating cycle. As a rule, a company's cash conversion cycle will be
influenced heavily by the type of product or service it provides and industry
characteristics.
Investors looking for investment quality in this area of a company's balance
sheet need to track the CCC over an extended period of time (for example, five
to 10 years), and compare its performance to that of competitors. Consistency
and/or decreases in the operating cycle are positive signals. Conversely,
erratic collection times and/or an increase in inventory on hand are generally
not positive investment-quality indicators. (To read more on CCC, see
Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.)
The Fixed Asset Turnover Ratio
Property, plant and equipment (PP&E), or fixed assets, is another of the "big"
numbers in a company's balance sheet. In fact, it often represents the single
largest component of a company's total assets. Readers should note that the
term fixed assets is the financial professional's shorthand for PP&E, although
investment literature sometimes refers to a company's total non-current assets
as its fixed assets.
A company's investment in fixed assets is dependent, to a large degree, on its
line of business. Some businesses are more capital intensive than others.
Natural resource and large capital equipment producers require a large amount
of fixed-asset investment. Service companies and computer software producers
need a relatively small amount of fixed assets. Mainstream manufacturers
generally have around 30-40% of their assets in PP&E. Accordingly, fixed asset
turnover ratios will vary among different industries.
The fixed asset turnover ratio is calculated as:
Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets
Average fixed assets can be calculated by dividing the year-end PP&E of two
fiscal periods (ex. 2004 and 2005 PP&E divided by two).
This fixed asset turnover ratio indicator, looked at over time and compared to
that of competitors, gives the investor an idea of how effectively a company's
management is using this large and important asset. It is a rough measure of
the productivity of a company's fixed assets with respect to generating sales.
The higher the number of times PP&E turns over, the better. Obviously,
investors should look for consistency or increasing fixed asset turnover rates
as positive balance sheet investment qualities.
The Return on Assets Ratio
Return on assets (ROA) is considered to be a profitability ratio - it shows how
much a company is earning on its total assets. Nevertheless, it is worthwhile
to view the ROA ratio as an indicator of asset performance.
The ROA ratio (percentage) is calculated as:
ROA = Net Income / Average Total Assets
Average total assets can be calculated by dividing the year-end total assets of
two fiscal periods (ex 2004 and 2005 PP&E divided by 2).
The ROA ratio is expressed as a percentage return by comparing net income, the
bottom line of the statement of income, to average total assets. A high
percentage return implies well-managed assets. Here again, the ROA ratio is
best employed as a comparative analysis of a company's own historical
performance and with companies in a similar line of business.
The Impact of Intangible Assets
Numerous non-physical assets are considered intangible assets, which can
essentially be categorized into three different types: intellectual property
(patents, copyrights, trademarks, brand names, etc.), deferred charges
(capitalized expenses) and purchased goodwill (the cost of an investment in
excess of book value).
Unfortunately, there is little uniformity in balance sheet presentations for
intangible assets or the terminology used in the account captions. Often,
intangibles are buried in other assets and only disclosed in a note to the
financials.
The dollars involved in intellectual property and deferred charges are
generally not material and, in most cases, don't warrant much analytical
scrutiny. However, investors are encouraged to take a careful look at the
amount of purchased goodwill in a company's balance sheet because some
investment professionals are uncomfortable with a large amount of purchased
goodwill. Today's acquired "beauty" sometimes turns into tomorrow's "beast".
Only time will tell if the acquisition price paid by the acquiring company was
really fair value. The return to the acquiring company will be realized only
if, in the future, it is able to turn the acquisition into positive earnings.
Conservative analysts will deduct the amount of purchased goodwill from
shareholders equity to arrive at a company's tangible net worth. In the absence
of any precise analytical measurement to make a judgment on the impact of this
deduction, try using plain common sense. If the deduction of purchased goodwill
has a material negative impact on a company's equity position, it should be a
matter of concern to investors. For example, a moderately leveraged balance
sheet might look really ugly if its debt liabilities are seriously in excess of
its tangible equity position.
Companies acquire other companies, so purchased goodwill is a fact of life in
financial accounting. Investors, however, need to look carefully at a
relatively large amount of purchased goodwill in a balance sheet. The impact of
this account on the investment quality of a balance sheet needs to be judged in
terms of its comparative size to shareholders' equity and the company's success
rate with acquisitions. This truly is a judgment call, but one that needs to be
considered thoughtfully.
Conclusion
Assets represent items of value that a company owns, has in its possession or
is due. Of the various types of items a company owns; receivables, inventory,
PP&E and intangibles are generally the four largest accounts in the asset side
of a balance sheet. As a consequence, a strong balance sheet is built on the
efficient management of these major asset types and a strong portfolio is built
on knowing how to read and analyze financials statements.
To learn more about reading balance sheets, see Breaking Down The Balance
Sheet, Reading The Balance Sheet and What You Need To Know About Financial
Statements.
by Richard Loth
Richard Loth has more than three decades of international experience in banking
(Citibank, Industrial National Bank, and Bank of Montreal), corporate financial
consulting, and non-profit development assistance programs. During the past 12
years, he has been a registered investment adviser and a published author of
books and publications on investing. Currently, he devotes his professional
activities to educational endeavors, writing and lecturing, aimed at helping
individual investors improve their investing know-how (see http://
www.lothinvest.com )