Wednesday, December 5, 2018

Profit Margins



         Gross Profit Margin = Gross Profit
                                       Net Revenue

The Gross Profit Margin expresses gross profit as a percentage of sales.  Gross profit is what remains after cost of good sold (or direct costs) are subtracted from revenues.

Note that net (as opposed to gross) revenue is used in the denominator of profit margins.  Sometimes a company will express “gross sales” less “returns and allowances,” equaling “net sales” on their income statement.  When a business presents both gross and net revenues, it is net revenues that are used in profit margins and common size reports.

A higher percentage (or profitability) is obviously desirable for this ratio.  The gross profit margin can be an invaluable indicator of performance and profitability (or pricing strategy) when compared with other firms in the industry.  It is among the most basic and widely used financial ratios.

         Operating Profit Margin = Operating Profit
                                                 Net Revenue

The Operating Profit Margin expresses operating profit (or net sales, less cost of sales, less operating expenses) as a percentage of net sales.  This is also a crucial measure of profitability, which is often compared to industry averages.

Company profit margins are also compared year over year, and trends are studied by management and financial analysts.


In this Street Smarts article on Inc.com, Norm Brodsky argues that the gross profit margin is the most important number on the income statement (http://www.inc.com/magazine/20081001/street-smarts-secrets-of-a-110-million-man.html).

Saturday, November 24, 2018

Debt to EBITDA

This multiple compares total debt to one year’s worth of Earnings before Interest, Taxes, Depreciation, and Amortization (or “EBITDA”).  EBITDA is, therefore, a proxy for funds available to service the debt.  The resulting multiple indicates how much EBITDA (or approximately how many periods) it would take to retire the debt with EBITDA.  This ratio is, therefore, a measure of “cash flow leverage”.

Obviously, a lower multiple indicates less leverage and lower risk.  Keep in mind that you are comparing a balance sheet item to an income statement measure with this ratio.  This can be problematic if the debt balance at the end of a given period is unusually high or low or if EBITDA is measured in only a partial year. 

Senior Debt to Tangible Net Worth plus Subordinated Debt

As discussed in the previous post, an analyst may want to exclude intangible assets from the calculation of net equity when constructing a debt to worth ratio.  You subtract net intangible assets from the denominator to make this adjustment.  This results in a higher (but more conservative and maybe also a more accurate) measurement of leverage.

Also described earlier, the debt to worth ratio represents capital contributed by creditors against capital contributed by owners.  If you examine the Smith Heating and Cooling, Inc. balance sheet, you will see that some of the company’s debt is actually due to a company owner.  An analyst might consider this to be a form of owner’s equity and alter the ratio accordingly to take a truer picture of leverage.

To do this, you would subtract loans from owners from total liabilities in the numerator and add the same amount to equity in the denominator.  Only “senior debt” or the bank debt in the first position in the event of liquidation is actually included as liabilities in this case.

Making these adjustments results in a “senior debt to tangible net worth plus subordinated debt” ratio.  For Smith Heating and Cooling, Inc., this ratio is $9.44 to 1, which is still pretty high.  The company is, indeed, highly leveraged.  But, the ratio is more meaningful in this case, and this number can be compared to an industry average to see how it measures up.

Thursday, July 5, 2018

Leverage and Debt to Worth



"Leverage" measures the extent to which debt is used to finance a business.  Higher leverage results from greater proportions of debt financing as opposed to equity financing, and greater risk generally accompanies higher leverage.  The most basic measure of leverage is the Debt to Worth Ratio:

          Debt to Worth = Total Liabilities
                                      Net Equity

The debt to worth ratio presents the relationship between capital contributed by lenders and capital contributed by owners.  Higher debt to worth implies more leverage and, therefore, more risk or potential for volatility.  A lower ratio implies that the business may have untapped borrowing capacity.

The debt to worth of Smith Heating and Cooling, Inc. is $234 to 1.  So, one might say that, for every dollar the owners have contributed, the company has borrowed $234 to operate the business.  This amount seems astronomical.  The business is indeed highly leveraged, but their debt to worth ratio is anomalous.  The ratio is not informative.

When equity is very small or negative due to losses on the income statement, the ratio loses its meaning.  A deficit or near zero equity position may be a problem itself, as losses have eroded the capital that was originally contributed by the owners.

Other balance sheet items may throw off the meaning of the debt to worth ratio as well.  For example, heavily depreciated buildings may cause an artificially high debt to worth if their market values are significantly higher than their book values.

The existence of intangible assets may have the opposite effect, by inflating equity with items that have little or no real value.  A solution is to calculate “tangible net worth” by excluding the book value of intangible assets.  You may then calculate a “Debt to Tangible Net Worth” ratio:

          Debt to Tangible Net Worth =             Total Liabilities             
                                                        Net Equity-Net Intangible Assets

Monday, July 2, 2018

Accounts Payable Turnover Ratios



          Accounts Payable Turnover =   Cost of Goods Sold
                                                             Accounts Payable

The Accounts Payable Turnover Ratio represents the average number of times per year that payables “turn over” or get paid with cash.  A higher (more rapid) turnover is generally favorable, since accounts payable are being paid more quickly.

But, paying debts too quickly uses up needed cash.  Many businesses extend these payments as much as possible to make the best use of their cash.  Businesses that manage their payables in this way or which receive extended payment terms from suppliers will, therefore, have lower (less rapid) accounts payable turnover.

At the same, businesses experiencing cash flow crunches or disputed invoices with their suppliers will also exhibit slower payables turnover.  Additional research is often necessary to determine the cause of slow or slowing accounts payable turnover.  Is it a sign of trouble or a result of good cash flow management?  To learn more, compare payables turnover to the industry average and to the payment terms of vendors.  Explore payables turnover from previous periods, and look for trends.

Like the other turnover ratios, this one compares cost of goods sold over a period of time with the accounts payable balance at a single point in time.  Perhaps the payables balance is inflated due to a seasonal buildup or a big discount from a supplier.  An analyst may compare purchases (as opposed to Cost of Goods Sold) to average accounts payable balances to obtain more meaningful ratios.

Days Payables Outstanding =                            365                   
                                                              Accounts Payable Turnover Ratio

“Days Payables Outstanding” expresses turnover as the average length of time in days between purchases and their payment.  Although, this ratio has the same limitations as the Accounts Payable Turnover Ratio, it may be more intuitive to look at payables turnover in terms of days rather than in number of times per period.

The payables of Smith Heating and Cooling, Inc. turn over 2.33 times per year or every 157 days.  This represents extraordinarily slow payables turnover.  The company’s accounts payable are certainly due in less than an average of 157 days.  An analyst would explore whether the company is experiencing cash flow problems that are resulting in very slow payments.

Thursday, June 28, 2018

Inventory Turnover Ratios



          Inventory Turnover = Cost of Goods Sold
                                               Inventory

Inventory turnover represents the average number of times per year that inventory "turns over" or that all goods are sold from inventory.  A higher, more rapid turnover is generally favorable, with goods being sold more quickly.  Rapid turnover may result from good inventory management, but it can be a symptom of an inventory shortage as well.

A lower, less rapid turnover may indicate overstocking or the presence of obsolescent goods.  Slow inventory turnover often coincides with liquidity problems, since working capital is tied up in inventory.  Slow inventory turnover may also result from planned seasonal build-ups or from making a large, bulk purchase to obtain a good price.

As with other turnover ratios, this one compares inventory at a single point in time to an entire period’s cost of sales.  To correct for seasonality or other anomaly, consider using average inventory in the denominator instead of the ending balance.

          Days Inventory Outstanding =                365                 
                                                          Inventory Turnover Ratio

This ratio expresses turnover as the average length of time in days between the purchase and the sale of inventory items.  A lower value (more rapid turnover) is generally more favorable, and interpretation and problems are similar to those of the Inventory Turnover Ratio.

The measures of liquidity for Smith Heating and Cooling, Inc. seemed to indicate that the company would be dependent upon inventory turnover to service short-term obligations.  Because of this, their inventory turnover ratios are crucial.

The company’s inventory turnover is only 2.11 times per year, so inventory is outstanding for an average of 173 days.  This is likely to be very problematic.  An analyst would want to explore how these rates compare to those of the company’s recent past as well as to those of other companies in the industry.  It would also be important to know if seasonal fluctuations are affecting the inventory balance and whether the goods are becoming obsolete as they sit.

Tuesday, June 26, 2018

Activity Ratios and Accounts Receivable Turnover


“Activity ratios” measure "turnover" or the rates at which current assets and current liabilities are used-up or paid-off through ordinary business operations.  Quicker turnover ratios generally imply greater efficiency and better management.  The first such ratio is the accounts receivable turnover ratio:

          Accounts Receivable Turnover = Annual Net Revenue
                                                               Accounts Receivable

Accounts receivable turnover represents the average number of times per year that trade receivables "turn over" or are converted to cash.  Higher, more rapid turnover is favorable, since sales on credit are being converted to cash more quickly.  Lower, less rapid turnover is unfavorable since default becomes more likely as receivables remain uncollected, and since conversion to cash is necessary to service obligations or to earn interest.

A problem with this ratio is the fact that it compares accounts receivable at a single point in time to an entire year of sales.  If the accounts receivable balance is unusually high or low on the date of the financial statements due to seasonal variations or other factors, then this measurement may not provide an accurate picture.  Substituting average receivable balances over the year in the denominator, may help correct this.

Another potential problem exists when cash sales represent a large percentage of total revenues.  The ratio will be very favorable in this case.  A more useful measure may be taken by considering only credit sales in the numerator.  Such a ratio is probably best used only in comparison with the company’s own historical turnover and with the actual payment terms the business requires of its customers.

Another way to look at accounts receivable turnover is in days:

          Days Receivables Outstanding=               365                           
                                                                Receivables Turnover Ratio

This ratio expresses the average length of time in number of days between sales and the cash collection of receivables.  The average number of days that receivables are outstanding can seem like a more intuitive measure than turnover expressed in number of times per year.  In this case, a lower value (or fewer days) is favorable because it represents more rapid turnover.

For Smith Heating and Cooling, Inc., accounts receivable turnover is 11.27 times per year, and the average number of days that receivables are outstanding is 32.39.  To put these numbers into better context, an analyst would compare them to receivables turnover from prior years, receivables turnover from similar businesses, and the company’s payment terms.  If Smith Heating and Cooling requires its customers to pay in thirty days, then receivables turnover is a bit slow.  If some customers pay cash at the time of service, then receivables collection may be really slow for those customers who pay on account.

Sunday, June 24, 2018

Quick Ratio or Acid Test


          Quick Ratio = Cash & equivalents + Current Accounts & Notes Receivable
                                                            Total Current Liabilities

The quick ratio or “acid test” is a more conservative measure of liquidity than the current ratio.  The numerator includes only the most liquid assets, and it excludes inventory and other accounts such as prepaid expenses.

Some accounting and finance experts simply present the quick ratio numerator as “Current Assets minus Inventory.”  This is the most basic way to calculate the quick ratio.  The quick ratio presented here is actually more conservative, since its assets include only cash, cash equivalents, and accounts and notes receivable due within a year.

A quick ratio below one implies that the business will be dependent upon turning its inventory to service short-term debts.  This may be problematic for a business that is susceptible to seasonal or cyclical fluctuations, a manufacturer with significant unfinished goods, or any business holding obsolete inventory.  If inventory is an issue for a business, then you may study their inventory and accounts receivable turnover ratios to learn more about their ability to turn inventory into cash.

For Smith Heating and Cooling, Inc., their quick ratio is 0.43 versus a current ratio of 1.12.  It appears that the company will, indeed, be dependent upon inventory turnover to service its short-term obligations.  For this reason, it will be important to carefully study the quality of the company’s inventory as well as their turnover ratios to perform a complete financial analysis.

Liquidity, Working Capital, and the Current Ratio


"Liquidity" (or "current position") is the measurement of a firm’s ability to service its short-term obligations through the "liquidation" of current assets.  Liquidation refers to the act of turning assets into cash, that is, selling inventory and collecting receivables and amounts due to the business.

The simplest measure of liquidity is “working capital,” or total current assets minus total current liabilities.  This measurement yields a dollar amount.  If the number is positive, then the business has a cushion of current assets over current liabilities.  A working capital shortfall may imply that a problem servicing obligations will arise during the upcoming year.

Perhaps the most commonly used measurement of liquidity is the “current ratio.”

Current Ratio = Total Current Assets / Total Current Liabilities

The current ratio is analogous to the calculation of working capital.  The difference is that the cushion between current assets and current liabilities is measured as a ratio instead of a dollar amount.

A current ratio above one implies that a cushion exists between current assets and current liabilities.  The higher the ratio, the greater the liquidity, since the coverage of current liabilities by current assets becomes larger.

It is also important to analyze the composition and quality of current assets.  Are they comprised primarily of cash and liquid assets?  Or, are most of the liquid assets comprised of receivables that may be difficult to collect or inventory which may be difficult to sell?

Liquidity ratios may also be affected by accounting policies such as whether a borrower uses LIFO, FIFO, or some other inventory valuation method.

Keep in mind that liquidity ratios are affected by seasonality and that the cash conversion cycle or the makeup of the balance sheet may affect liquidity ratios.  For example, a business with a high concentration of fixed assets financed by long-term debt, but with no inventory or receivables, may appear to have liquidity issues (due to the current portion of long-term debt within the denominator of the current ratio).  If fixed assets (as opposed to sales from inventory) generate consistent cash flow, then this income may be sufficient to service the debt and current obligations.  In such a case, an analysis of the cash flows and the debt service coverage ratios may be a better indicator of liquidity.

For Smith Heating and Cooling, Inc., current assets total $309,000, while current liabilities add up to $275,000.  This means that the company has working capital of $34,000 and a current ratio of 1.12.

In this Street Smarts article on Inc.com, Norm Brodsky argues that paying attention to working capital and the current ratio are essential to success in business.

Sample Income Statement


Sample Balance Sheet



Financial Statement Quality


Financial statements may be prepared internally a business or externally by an accountant.  Historical statements that have been prepared by a Certified Public Accountant will explain the level of examination that has been made in a letter preceding the statements.  The levels of CPA-prepared financial statements are:

Compiled: These statements have been put together by a CPA, and, therefore, should be correct with respect to format.  However, the accountant makes no opinion as to the accuracy of the numbers, and the accountant is not required to be independent of the business.

Reviewed: The statements are examined for accuracy by the accountant, but the scope of the examination is significantly smaller that of an audit.

Qualified Audit: In an audit, the accountant strictly examines the financial statements.  Account balances including loans, deposits, receivables, payables, and inventory are audited, and a selection of individual transactions is tested for accuracy.  The auditor also examines the internal controls of the business and expresses an opinion on the ability of the firm to continue as a going-concern.

An audit is considered "qualified" because there is some discrepancy or disagreement between the figures of the business and the auditor's findings.  Any such discrepancies will be explicitly listed in the letter preceding the statements.

Unqualified Audit: This is also a strict examination as described above, except that no discrepancies exist between the business and the auditor.

Cash Basis Versus Accrual Basis Accounting


There are two methods of accounting and financial statement preparation, “cash basis” and “accrual basis.”  Cash basis accounting does not use accounts receivable and accounts payable; instead, income is booked when cash is actually received, and expenses are booked when checks are written.  Many small businesses use cash basis accounting, because it is easier to perform, and it involves fewer entries and less bookkeeping.  Many businesses also use the cash basis for their income tax returns.  It can minimize taxable income, since sales are not booked until payment is received.

Virtually all big businesses use accrual accounting (including accounts receivable and accounts payable) for their financial reporting.  Accrual accounting is beneficial because of the “matching” principle.  The use of accrual accounting allows revenues to be matched with corresponding expenses that are incurred in the same period (without regard for when the cash actually comes in or goes out the door.)  This often allows financial statement analysis to be more meaningful (for both the company and outside analysts.)

Accrual accounting can be easily converted to cash basis accounting; in fact, most accounting programs allow you to choose to create either cash or accrual reports.  But, conversely, cash accounting cannot be converted to accrual accounting without the receipt of additional information.

Equity


Equity represents the difference between the assets and the liabilities of a business.  On the balance sheet, “Total Assets” minus “Total Liabilities” equals “Net Equity.”  Quite a few types of equity accounts exist on balance sheets.

All corporations issue “common stock,” which is the most basic form of ownership of a corporation.  Stock equity may also be referred to as “Paid-In Capital” on a corporate balance sheet.  Some balance sheets include an “Additional Paid-In Capital” account as well, representing excess funds invested in stock over and above its arbitrary “par value.”

If a corporation subsequently purchases some of its stock back from shareholders, the amounts paid in these transactions are booked as “Treasury Stock.”  Treasury stock will, therefore, have a negative balance as an equity account.

Other forms of business ownership may use somewhat different terminology than this; however, all businesses will have “retained earnings,” which simply represent the sum of all of their profits and losses for all periods.

Notes Payable


Notes payable are loans due to banks or other creditors.  A “note” is a legal contract; it represents an obligation to repay a debt.  A note payable may be either current or non-current or a combination of both.  “Notes Payable” are often individually listed on the balance sheet, and the amounts represent outstanding principal balances only.

Most notes payable consist of long-term loans (or mortgages) that are repaid in installments.  These notes are listed as non-current liabilities on the balance sheet.  However, the sum of principal payments due in the upcoming year are subtracted and listed separately as current liabilities called, “Current Portion of Long-Term Debt” or “Current Maturities of Long-Term Debt”

If a note payable, such as a revolving line of credit or a loan coming due, expires or balloons within the year, then the entire balance is listed as a current liability.

Accounts Payable


An account payable is an amount due to a vendor from which a business has purchased goods or services “on account.”  “Accounts Payable,” the plural form of the term, is a current liability listed on the balance sheet representing the total outstanding payables on the date of the statement.

Accounts payable are analogous to accounts receivable; the vendor making a sale on credit books an account receivable, while the purchaser books an account payable.

Intangible Assets


An intangible asset exists only on paper or in accounting transactions; it is not a physical item or a receivable.  Instead, it is an intangible item, such as a patent, copyright, or goodwill.  (“Goodwill” represents the price paid for the assets of a business over and above the book value.)

Ownership of an intangible asset often leads to some type of income generation or cost savings.  Intangible assets, therefore, have value, and they are listed on the balance sheet as non-current assets.

Intangible assets are written off slowly over time in a similar manner as fixed assets.  They are gradually written down or “amortized” over their existence.  For example, a patent would be amortized until its expiration.  Similarly, expenditures made for loan costs or franchise fees are generally capitalized and amortized as well.

Fixed Assets and Depreciation


A fixed asset is a physical item, such as a piece of equipment, a vehicle, or real property.  Fixed asset expenditures must be “capitalized;” that is, they are listed as assets on the balance sheet, as opposed to being expensed on the income statement.  Fixed assets are considered non-current, and they are listed on the balance sheet at their historical costs.

Fixed assets are “depreciated” over time, and “depreciation” is an expense that is listed on the income statement.  Each period, a fixed asset receives some depreciation write-down until its useful life is used up.  The length of time over which a fixed asset is depreciated very roughly approximates its useful life.  For example, a computer may be depreciated over five years, while a building may be depreciated over twenty or even as many as forty years.

The balance sheet usually lists gross amounts of fixed assets (at historical cost) in categories such as “Office Equipment,” “Vehicles,” and “Real Estate.”  The sum of these amounts represents “Gross Fixed Assets.”  “Accumulated Depreciation” is typically listed next, consisting of the sum of all depreciation expense, past and present.

So, on the balance sheet, “Gross Fixed Assets” less “Accumulated Depreciation” equals “Net Fixed Assets.”

Inventory Valuation


Over time, many businesses build up inventories of goods available for sale.  Prices change; they generally increase over time due to inflation.  Because of this effect, an item that cost the business one amount a year ago, may cost more when purchased today.  A decision must be made as to which item gets sold and removed from inventory.  This decision affects both the inventory value as well as the cost of goods sold account related to the sale.

A popular method of inventory valuation is LIFO or, “last in, first out.”  In other words, the most recent cost (often the most expensive) is the one that is removed from inventory and booked as the cost of goods sold.  This method minimizes profits (and therefore income taxes.)

Another method is FIFO or, “first in, first out.”  Using this method, the oldest cost is the one that is booked.  Some businesses may also use an “average cost” method to value inventory and book costs of goods sold.

When a company uses LIFO, it will list a “LIFO Reserve” on its balance sheet or in the footnotes to the financial statements.  The LIFO reserve represents the difference between LIFO and FIFO; it is the amount by which inventory under LIFO would be adjusted to be valued using FIFO.

Another important aspect of inventory valuation and inventory analysis involves whether the business regularly conducts a physical count of its inventory.  This activity helps ensure that the stated balance is accurate and identifies “shrinkage” or loss of inventory due to misplacement, theft, and bookkeeping error.  Similarly, businesses occasionally write off obsolete inventory that no longer has value or cannot be sold.  If the business has not performed an inventory count or written off obsolete items, then the inventory value on the balance sheet is likely to be overstated.

Inventory


Inventory consists of goods that are held for sale.  “Inventory” is a current asset account listed on the balance sheet.  Inventory might consist of raw materials, work-in-progress, or finished goods.

The quality of inventory is explored by financial analysts.  For example, raw materials and finished goods typically have more value in liquidation (and therefore as collateral) than work-in-progress.  Inventory that has become obsolete may also have decreased value.

Accounts Receivable


Accounts receivable are amounts due from customers who have purchased goods or services “on account.”  Such accounts are typically due within thirty days or on a certain date each month.

“Accounts Receivable” is a current asset account that is listed on the balance sheet.  “Accounts receivable” is the proper plural form of the singular, “account receivable.”

The quality of accounts receivable is an important aspect of financial statement analysis.  Analysts explore whether payments are being received in a timely manner as well as from whom the receivables are due and whether the customers are creditworthy.

Current and Non-Current


There are two types of assets and liabilities, “current” and “non-current.”  Current assets are those that are expected to be converted to cash in one year or less, and current liabilities are those that will come due in one year or less.  So, cash, marketable securities, accounts receivable, and inventory are all considered current assets, while accounts payable and the principal amounts of loans due within a year are considered current liabilities.

Non-current assets and non-current liabilities are due or converted to cash in more than a year.  Fixed assets and intangible assets are considered non-current, and loan amounts which are due in more than a year are also considered non-current.

The Income Statement


The “income statement” (or “profit and loss” or “P & L”) presents income and expenses over a period of time.  It is important to note that the income statement covers a range of dates, usually an entire month, quarter, or year.  The statement starts by listing income or “revenues” or the “top line.”

Direct costs or “cost of goods sold” are then subtracted from revenues to arrive at “gross profit.”  Note that direct costs are generally variable in nature; that is, these costs directly correspond to revenues and vary along with them.  For example, a store sells a television.  The amount that the store originally paid to the manufacturer for the television represents a “cost of goods sold.”  This cost is directly related to the revenue that the store earns from the customer.  To further illustrate, when the manufacturer sells another television to the store, the labor and materials that go into making it represent direct costs to the manufacturer.

Next, operating or “general” expenses or “overhead,” such as rent and office supplies are subtracted to arrive at “operating profit.”  Operating costs are generally fixed in nature, as they tend not to increase in the short-term.  For example, a company’s rent often remains the same for months or years at a time.  Similarly, operating costs such as rent are not directly tied to any specific sales transactions.

Finally, non-operating and extraordinary items such as interest expense and income taxes are subtracted to arrive at net income or the “bottom line.”  An income statement might have the following format:

Gross Revenue (or “sales” or “income”)
Less: Returns & Allowances
Equals: Net Revenue

Less: Direct Costs (or “cost of goods sold”)
Equals: Gross Profit

Less: Operating Expenses (or “overhead”)
Equals: Operating Profit

Less: Non-Operating Expenses
Equals Net Income

The Balance Sheet


The “balance sheet” is the financial statement that lists account balances on a given date.  The important thing to remember is that it represents a single moment in time.  The statement is referred to as the “balance sheet” because it presents balances in the asset, liability, and equity accounts at the end of business on a certain date.

The balance sheet lists assets such as bank deposits, accounts receivable, inventory, and equipment, as well as liabilities like loans and accounts payable.

“Equity” is the difference between the assets and the liabilities of a business; equity can also be described as “what you own, less what you owe.”  So, the formula for a balance sheet is as follows:

assets - liabilities = equity, or

assets = liabilities + equity.

The balance sheet actually contains two “sides” or two sections.  One side consists of assets, and the other side consists of liabilities plus equity.  The sum of each of these two sides must equal each other or be in “balance.”  Perhaps, this is another reason why the statement is referred to as the “balance sheet.”