Reading Financial Reports for Dummies (39 page)

If the company you’re evaluating has a slower than average inventory turnover, look for explanations in the management’s discussion and analysis and the notes to the financial statements to find out why the company is performing worse than its competitors. If the rate is higher, look for explanations for that as well; don’t get too excited until you know the reason why. The better numbers may be because of a one-time inventory change.

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Investigating Fixed Assets Turnover

Next, you want to test how efficiently a company uses its fixed assets to generate sales, a ratio known as the
fixed assets turnover. Fixed assets
are assets that a company holds for business use for more than one year and that aren’t likely to be converted to cash any time soon. Fixed assets include items such as buildings, land, manufacturing plants, equipment, and furnishings. Using the fixed assets turnover ratio, you can determine how much per dollar of sales is tied up in buying and maintaining these long-term assets versus how much is tied up in assets that are more quickly used up.

If the economy goes sour and sales drop, reducing variable costs is much easier than reducing costs for maintaining fixed assets. The higher the fixed assets turnover ratio, the more nimble a company can be when responding to economic slowdowns.

Calculating fixed assets turnover

The fixed assets turnover ratio formula is

Net sales ÷ Net fixed assets = Fixed assets turnover ratio I show you how to calculate this ratio by using the net sales figures from Mattel’s and Hasbro’s income statements and the fixed assets figures from their balance sheets. For both companies, use the line item “Property, plant, and equipment, net.” (If a company doesn’t calculate its fixed assets for you, you have to add several line items together, such as buildings, tools, and equipment.)

Mattel

$5,970,090,000 (Net sales) ÷ $518,616,000 (Net fixed assets) = 11.51 (Fixed assets turnover ratio)

Hasbro

$3,837,557,000 (Net sales) ÷ $187,960,000 (Net fixed assets) = 20.42 (Fixed assets turnover ratio)

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What do the numbers mean?

A higher fixed assets turnover ratio usually means that a company has less money tied up in fixed assets for each dollar of sales revenue that it generates. If the ratio is declining, that can mean that the company is over-invested in fixed assets, such as plants and equipment. To improve the ratio, the company may need to close some of its plants and/or sell equipment it no longer needs.

You can tell whether a company’s fixed asset turnover ratio is increasing or decreasing by calculating the ratio for several years and comparing the results. The balance sheet includes two years’ worth of data, so in this example, you may be able to find the financial statements for 2005 online, or if not, you can request them. Then you’d have the data for 2007 and 2006 on the 2007 balance sheet, and you’d have the data for 2005 and 2004 on the 2005

balance sheet.

Tracking Total Asset Turnover

Finally, you can look at how well a company manages its assets overall by calculating its total asset turnover. Rather than just looking at inventories or fixed assets, the
total asset turnover
measures how efficiently a company uses all its assets.

Calculating total asset turnover

The formula for calculating total asset turnover is

Net sales ÷ Total assets = Total asset turnover

I use information from Mattel’s and Hasbro’s income statements and balance sheets to show you how to calculate total asset turnover. You can find the net sales at the top of the income statement and the total assets at the bottom of the assets section on the balance sheet. Here are the calculations: Mattel

$5,970,090,000 (Net sales) ÷ $4,805,455,000 (Total assets) = 1.24 (Total asset turnover)

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Hasbro

$3,837,557,000 (Net sales) ÷ $3,237,063,000 (Total assets) = 1.18 (Total asset turnover)

What do the numbers mean?

Mattel and Hasbro have similar asset ratios, so their efficiency in using their total assets to generate revenue is about equal. Both companies hold more than half their assets in current assets, which means that they’re relatively liquid and can respond quickly to industry changes.

A higher asset turnover ratio means that a company is likely to have a higher return on its assets, which some investors believe can compensate if the company has a low profit ratio. By
compensate,
I mean that the higher return on assets could mean increased valuation for the company and, therefore, a higher stock price.

In addition to looking at this ratio, when determining stock value, you need to calculate the profit ratios and return on assets (I show you how to calculate these in Chapter 11). Aside from inventory turnover, another key asset to consider is accounts receivable turnover, which I discuss in Chapter 16.

Chapter 16

Examining Cash

Inflow and Outflow

In This Chapter

▶ Discovering the ins and outs of accounts receivable

▶ Considering the nuts and bolts of accounts payable

▶ Digging into discount offers

Is the money flowing? That’s the million-dollar, and sometimes multimillion-dollar, question. Measuring how well a company manages its inflow and outflow of cash is crucial to being able to stay in business. Cash is king in business — without it, you can’t pay the bills.

In this chapter, I review the key ratios for gauging cash flow and I show you how to calculate them. In addition, I explore how companies use their internal financial reporting to monitor slow-paying customers, and I discuss whether paying bills early or on time is better and how you can test that issue.

Assessing Accounts Receivable Turnover

Sales are great, but if customers don’t pay on time, the sales aren’t worth much to a business. In fact, someone who doesn’t pay for the products he takes is no better for business than a thief. When you’re assessing a company’s future prospects, one of the best ways to judge how well it’s managing its cash flow is to calculate the accounts receivable turnover ratio.

A balance sheet lists customer credit accounts under the line item “accounts receivable.” Any company that sells its goods on credit to customers must keep track of whom it extends credit to and whether those customers pay their bills.

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Financial transactions involving credit card sales aren’t figured into accounts receivable but are handled like cash. The type of credit I’m referring to here is
in-store credit,
which is when the bill the customer receives comes directly from the store or company where the customer purchased the item.

When a store makes a sale on credit, it enters the purchase on the customer’s credit account. At the end of each billing period, the store or company sends the customer a bill for the purchases she made on credit. The customer usually has between 10 and 30 days from the billing date to pay the bill. When you calculate the
accounts receivable turnover ratio,
you’re seeing how fast the customers are actually paying those bills.

Calculating accounts receivable turnover

Here’s the three-step formula for testing accounts receivable turnover:
1. Calculate the average accounts receivable:

Add the current year’s accounts receivable and the previous year’s accounts receivable and divide by 2.

2. Find the accounts receivable turnover ratio:

Net sales ÷ Average accounts receivable = Accounts receivable turnover ratio

3. Find the average sales credit period (the time it takes customers to
pay their bills):

52 weeks ÷ Accounts receivable turnover ratio = Average sales credit period

If you work inside the company, an even better test is to use annual credit sales rather than net sales because net sales include both cash and credit sales. But if you’re an outsider reading the financial statements, you can’t find out the credit sales number.

I show you how to test accounts receivable turnover by using Mattel’s and Hasbro’s 2007 income statements and balance sheets.

Mattel

1. Calculate the average accounts receivable:

($991,196,000 + $943,813,000)/2 = $967,504,500

2. Find Mattel’s accounts receivable turnover ratio for 2007:
$5,970,090,000 (Net sales) ÷ $967,504,500 (Average accounts receivable)

= 6.17 times

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3. Find the average credit collection period:

52 weeks ÷ 6.17 (Accounts receivable turnover ratio) = 8.4 weeks Mattel’s customers averaged about 8.4 weeks to pay their bills.

Comparing this data with the previous year’s is a good way to see whether the situation is getting better or worse. If you use the same process to calculate Mattel’s 2006 average credit collection period, you find the answer is 8.69

weeks, meaning that the company took slightly longer in 2006 to collect than it did in 2007. To understand the significance of this, look at what’s happening with similar companies as well as what’s happening within the industry as a whole. It may be an internal company problem or it may be an industry-wide problem related to changes in the economic situation.

Hasbro

1. Calculate Hasbro’s average accounts receivable:

($654,789,000 + $556,287,000)/2 = $605,538,000

2. Calculate Hasbro’s accounts receivable turnover ratio for 2007:
$3,837,557,000 (Net sales) ÷ $605,538,000 (Average accounts receivable)

= 6.34 times

3. Calculate the average sales credit period:

52 weeks ÷ 6.34 (Accounts receivable turnover ratio) = 8.21 weeks Hasbro’s accounts receivable turned over at a rate slightly faster than Mattel’s.

Is that an improvement or a step backward for Hasbro? Using the 2006

numbers, you find that Hasbro took 8.91 weeks to collect from its customers.

That means that the company experienced an improvement in its accounts receivable collection.

What do the numbers mean?

The higher an accounts receivable turnover ratio is, the faster a company’s customers are paying their bills. Most times, the accounts receivable collection is directly related to the credit policies that the company sets. For example, a high turnover ratio may look very good, but that ratio may also mean that the company’s credit policies are too strict and that it’s losing sales because few customers qualify for credit. A low accounts receivable turnover ratio usually means that a company’s credit policies are too loose, and the company may not be doing a good job of collecting on its accounts.

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Finding the right credit policy

Setting the right accounts receivable policy can

Looking at the other side of the coin, a credit

have a major impact on sales. For example, a

policy that’s too loose may allow customers 60

company could require customers to pay within

days to pay their accounts. By the time the com-

ten days of billing or close the accounts. That

pany realizes that it has a nonpaying customer,

may be too strict, and customers could end up

the customer may have already charged a large

having to walk out of the store because they

sum to the account. If the customer never pays

can’t charge to the account. Another common

the amount due, the company has to write it off

credit policy that may be too strict is one that

as a bad debt.

requires too high a salary level to qualify, forc-

ing too many customers to go elsewhere to buy

the products they need.

According to its balance sheets, Mattel wrote off $21.5 million in bad debt in 2007 and $19.4 million in 2006. Hasbro wrote off a lot more: $30.6 million in 2007 and $27.7 million in 2006. Hasbro not only has slower-paying customers but also writes off more to bad debt.

Hasbro’s customers took an average of 8.21 weeks to pay their bills in 2007.

Mattel’s customers took a bit longer at 8.4 weeks. Both companies wait about two months to get paid. The amount sitting in accounts receivable for Mattel increased by about $50 million between 2006 and 2007. Hasbro experienced an increase in accounts receivable of almost $100 million.

As an investor, you may want to call Hasbro’s investor-relations department to find out about its longer accounts receivable collections period and its bad-debt write-offs, as well as what the company is doing to improve these numbers.

Taking a Close Look at

Customer Accounts

If you work inside a company and have responsibility for customer accounts, you get an internal financial report called the
accounts receivable aging schedule.
This schedule summarizes the customers with outstanding accounts, the amounts they have outstanding, and the number of days that their bills are outstanding. Each company designs its own report, so they don’t all look the same. Check out Table 16-1 to see an example of an accounts receivable aging schedule.

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Table 16-1

Accounts Receivable Aging Schedule

for ABC Company, as of March 31, 2008

Customer

30–45

46–60

61–90

Over 90

Total

Days

Days

Days

Days

DE

$100

$50

$0

$0

$150

Company

FG

$200

$0

$0

$0

$200

Company

HI

$200