BALANCE SHEET RATIOS Kott Capital

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BALANCE SHEET RATIOS Kott Capital Powered By Docstoc
					     MARKET STRATEGIST
         Email: vince@kottcapital.com

     Web Address: www.kottcapital.com
                                                            eeTHE BIGGER PICTURE
                                                          Balance Sheet Ratios

                                                          Internal Liquidity Ratios
BALANCE SHEET ANALYSIS
                                                          Operating Efficiency Ratios

                                                          Leverage Ratios

                                                          Balance Sheet Items

                                                          Finding Yellow Flags in Financial Statements



Balance Sheet Analysis: Characteristics

You rarely see an analyst say sell a stock because of deteriorating balance sheets and losses
probably ahead.

Use an average of two periods, to best mimic the period-spanning nature of the income
statement and cash flow statement data.




BALANCE SHEET RATIOS

Balance Sheet Strength Ratio: Guidelines

Current Ratio / 4

Divide S.E. by Total Assets
2


Add these 2 together

Over 1 indicates a strong balance sheet. Under 0.80 indicates a weak balance sheet




INTERNAL LIQUIDITY RATIOS


Internal Liquidity Ratios

Working Capital

Trade Working Capital

Current Ratio

Quick Ratio

Working Capital/ Sales




Internal liquidity ratios: Characteristics

Provide information on the immediate cash availability or liquidity of the enterprise and also,
in the measurement across multiple periods, how consistently a company maintains its
liquidity.




WORKING CAPITAL RATIO




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Working Capital: Guidelines

WC/Current Liabilities = Coverage Ratio

130% is great. 40% is average in 1989

Measures the difference between a company’s current assets and current liabilities.

High levels of working capital have been regarded positively because they show a company as
being highly liquid to meet immediate cash needs.

In a downturn, high working capital can serve as a kind of “bank” for the well-managed
enterprise.

Key current asset accounts (principally, accounts receivable and inventories) can be drawn
down, which is contributory to cash flow and may help keep cash flow positive amid negative
profit performance.

Poor working capital management in a down cycle, on the other hand, is seen by investors as
an indictment of management.




WORKING TRADE CAPITAL RATIO


Trade Working Trade Capital : Characteristics

Include only the principal operating line items in current accounts. These are accounts
receivable and inventories from current accounts, and accounts payable from current
liabilities when compared to traditional working capital.




CURRENT RATIO


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Current Ratio: Guidelines

Current Ratio should exceed 1.6.

Investors prefer to see current accounts at two or more times the level of current liabilities (a
current ratio of 2.0).

Current Ratio trending below 2 is not good.

Non typical current ratios can include finance and energy; industries can include retail and
other consumer-sensitive areas.

Current-ratio changes across the cycle speak volumes about management responsiveness in a
dynamic environment.




QUICK RATIO



Quick Ratio: Guidelines

Considered by some investors a better gauge of liquidity and cash availability than current
ratio.

Creditors like to see a quick ratio exceeding 1; again, there can be some sector-based and
industry-based variability in average ratios.

It has informational value, particularly in times of financial distress.




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WORKING CAPITAL / SALES RATIO




Working Capital/Sales Ratio: Guidelines

Track this figure to gauge a company’s ability to finance a higher level of sales from existing
capacity—that is, without incurring additional short-term debt.

Watching this ratio is particularly useful in times of economic distress. As the economy
weakens and company revenues decline in tandem, working capital should be reduced, to
lessen strains on cash use and to help maintain positive cash flows.

Investors want to see this ratio hold constant in trying times. A decline in the ratio would
signal distress at the company itself and an inability to fund sales at current levels.




OPERATING EFFICIENCY RATIOS


Operating Efficiency Ratios

Receivables Turnover

Receivables Collection Period

Total Asset Turnover

Inventory Turnover

Inventory Collection Period

Days Sales Outstanding

Fixed Asset Turnover




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Equity Turnover

Payables Turnover

Payables Days Outstanding

Cash Conversion Cycle




Operating Efficiency Ratios: Characteristics

Measure execution and efficacy of asset use.

A cash-rich company operating in high-margin niches can mask a flawed operating strategy or
sloppy execution; the operating efficiency ratios provide early warnings on such company.




RECEIVABLES TURNOVER


Receivables turnover: Guidelines

Describes the duration of accounts receivable.

A high turnover figure is desirable, because it shows that the enterprise collects its
receivables efficiently and effectively and that it does business with good credits.

Low receivables turnover ratios may signal struggling customers and can be a prelude to the
use of factoring companies to securitize or otherwise take poor-quality receivables off the
balance sheet at a discount.

Receivables turnover is also viewed as a good indicator for cash flow and for operating
performance in general.




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RECEIVABLES DAYS OUTSTANDING / RECEIVABLES COLLECTION PERIOD




Receivables days outstanding/ Receivables Collection Period: Guidelines

This tells us how many days are required to turn over average receivables.

Information measured in days is essential to determining days sales outstanding and cash
cycle, widely viewed as measures of operating efficiency and—indirectly—the quality and
solvency of customers.




TOTAL ASSET TURNOVER


Total Asset Turnover: Guidelines

Information-rich reading on the underlying efficiency of an enterprise.

Some investors and analysts are more interested in a cleaner asset return number, so they
strip out intangibles and goodwill from total assets.




INVENTORY TURNOVER




Inventory Turnover: Guidelines

Provides insight on how well the supply chain is functioning and how optimally procurement




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officers are making purchases.

The important distinction between accounts receivable turnover and inventory turnover is in
the denominator: inventories are measured as a multiple of cost of goods sold, not of
revenues.

To calculate inventory turnover in a cell, divide cost of goods sold for a given year by the two-
period average of total inventories, using most recent annual period and nearest prior annual
period.




INVENTORY COLLECTION PERIOD


Inventory Collection Period: Guidelines

Inventory collection period is also a referendum on the quality and solvency of customers,
pricing power, market share trends, and many other useful (though not easily quantifiable)
data points.

To calculate inventory collection period in a cell, we use receivables turnover and divide it by
the days in the period, or 365 days.




DAYS SALES OUTSTANDING


Days Sales Outstanding: Guidelines

Divide accounts receivable for the period by revenues and multiply the result by the days in
the period.




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FIXED ASSET TURNOVER


Fixed Asset Turnover: Guidelines

For informational and comparison purposes.

Fixed asset turnover indicates the revenue generated by the money spent on PP&E. Because
PP&E is depreciated over time while sales presumably are growing, in a normally progressing
company this ratio should be increasing.

If this ratio flattens out or begins a sustained fade (as opposed to a cyclical blip), that can be a
sign that a company has invested unwisely in unproductive assets.




EQUITY TURNOVER




Equity turnover: Guidelines

For informational and comparison purposes.

Equity Turnover Shareholders’ equity is share capital plus retained earnings minus treasury
shares, and a few other items such as accumulated other comprehensive income and foreign
exchange can impact this number.

Shareholders’ equity can be calculated by what it isn’t: assets less liabilities.




PAYABLES TURNOVER




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Payables turnover: Guidelines

Play a role in determining cash cycle, perhaps the single best measure of operating efficiency.

In a normally functioning economy, a company’s ratio of what it pays out to its vendors
should about track the rate of sales growth.

In a weakening economy, payables will decline; in a recovering economy, payables will rise as
companies prep for higher activity levels.

Because revenue recognition can introduce lags, cyclical changes can distort payables
turnover.

A deterioration in payables turnover would signal acquired consumables (i.e., payments to
vendors) are not generating the necessary level of sales growth.




PAYABLES DAYS OUTSTANDING




Payables days outstanding (PDO): Guidelines

Play a role in determining cash cycle, perhaps the single best measure of operating efficiency.

In a normally functioning economy, a company’s ratio of what it pays out to its vendors
should about track the rate of sales growth.

In a weakening economy, payables will decline; in a recovering economy, payables will rise as
companies prep for higher activity levels.




CASH CONVERSION CYCLE


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Cash Conversion Cycle: Guidelines

Sometimes called cash conversion cycle, measures the length of time taken to convert inputs
into cash flows.

It measure the time between the purchase of raw materials and the collection of accounts
receivable on items or services sold.

Would like to see cash cycle shorten rather than lengthen.

In tough times, companies typically seek to mitigate downshifts in operating cash flow by
reducing working capital.

Given lags in revenue recognition, this can have short-term distortive effects on cash cycle.

Less concerned with cyclical blips and more concerned with structural lengthening or
shortening in the cash cycle.

To calculate cash conversion cycle in a cell, add receivables days outstanding and inventory
days outstanding and subtract payables days outstanding.




LEVERAGE RATIOS



Leverage Ratios

Operating Leverage

Times Interest Earned

Debt to Equity




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Debt to Capitalization

Shareholder’s Equity to Total Assets




OPERATING LEVERAGE


Operating Leverage: Guidelines

Measures the magnitude of change in operating earnings in relation to changes in revenue
levels.

While it is too simple to say avoid high-fixed-cost companies heading into a downturn and
buy them heading into recovery, awareness of the effects of operating leverage on a
proposed investment should be part of the investment decision.

Operating leverage calculations are expressed as a percentage.




TIMES INTEREST EARNED


Times Interest Earned: Guidelines

Times interest earned is sometimes called interest coverage or coverage ratio.

Measures a company’s ability to meet the accounting interest obligations on its debt.

Investors typically use EBIT, or earnings before interest and taxes.




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DEBT TO EQUITY RATIO


Debt/Equity: Guidelines

Debt/equity provides a quick snapshot on how a company chooses to fund its strategy: with a
preponderance of debt, with equity, or with a balanced approach.

Investors typically calculate both long-term debt/equity and total debt/equity.

Generally companies with ratios above 1 are considered high debt.




DEBT/ CAPITALIZATION RATIO


Debt/Capitalization: Guidelines

High debt/cap ratios can be problematic but also that debt/cap is really most useful in a peer
group comparison.

Certain stable industries with high capital intensity, such as utilities, are characterized by high
debt/cap ratios.

Other industries, including much of technology, are characterized by generally low debt/cap
ratios.

When there is a meaningful gapbetween measure both total debt to cap along with long-term
debt/cap, that usually signals maturing debt moved to current.

If there is a meaningful gulf between total debt/cap and long-term debt/cap on a sustained
basis, however that may indicate that a company is straining to operate profitably with its
working capital resource.




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SHAREHOLDER’S EQUITY TO TOTAL ASSET RATIO




Shareholder’s equity to Total Assets Ratio: Guidelines

Common shareholder’s equity should be at least 45% of total assets.

Less long term debt than stockholder’s equity.




BALANCE SHEET ITEMS


Balance Sheet Items

Inventories

Receivables

Depreciation

Non Recurring Charges

Goodwill

Property, plant & equipment (PP&E)




INVENTORIES


Inventories: Guidelines

Inventories should have grown no faster over the last three years than did total annual




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revenues.

Bulging inventories are management’s prime pocket for hiding upcoming loses.

Don’t want inventories rising relative to sales. It is worst if sales are slowing and inventories
are rising.




RECEIVABLES


Receivables: Guidelines

Increasing receivables relative to sales could signal troubles.




DEPRECIATION


Depreciation: Guidelines
Don’t want recent annual depreciation charge exceed capital expenditures in the same year.




NONRECURRING CHARGES


Nonrecurring charges: Guidelines
Don’t want non-recurring charges percentage of sales 3% or more over the past 5 years




GOODWILL



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Goodwill: Guidelines

Amortization of goodwill, a noncash charge, can artificially depress reported earnings.




PROPERTY, PLANT & EQUIPMENT



Property, Plants & Equipment: Guidelines

Plant and equipment may be outmoded or obsolete and therefore worth considerably less
than carrying value. Book value may be overstated.




FINDING YELLOW FLAGS IN FINANCIAL STATEMENTS

Finding Yellow flags: Characteristics

Create a common size income statement by expression each line items as a percentage of net
sales revenue and include at least 5 years of historical data.

Plotting these items on a graph will facilitate identifying trends and irregularities.

Two elements needed to be identified when management is manipulating the income
statement: timing and the value of the line item.

Put at least five years or 12 quarters of each line item as a percentage of total assets. Look for




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items that are experiencing significant change over time.

When analyzing individual line items within the balance sheet, the objective is to detect weak
liquidity or excessive leverage and to identify assets that are overstated or liabilities that are
understated.



Reading Financial Statements: Guidelines

When you read an annual report, start in the back, with the footnotes.

Things to look for:

Unconsolidated finance subsidiaries.

Changes to depreciation policies.

Inventory costing.

Pension plan assets that are less than promised or have reduced actuarial assumptions.




General Yellow Flags: Characteristics

Accounting irregularities near IPO selling expiration.

If the senior executive team is receiving more than 50% of its compensation in stock.

A firm close to violating its debt covenants might resort to financial statement manipulation.

Studies shows that instance where a company needs to raise capital, there is often earnings
mgmt.

A firm in index might manipulate numbers not to get dropped from the index.




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Unsustainable increases in ASP can come from: currency gains, special assessments to cover
higher expenses, change in mix and change in revenue recognition.

Important to look at how much revenue is coming from changes in volume versus average
selling price (ASP).

Change in auditors.

Negative audit opinions.

High Management turnover.

Weak Corporate Governance.




YELLOW FLAGS IN INCOME STATEMENT


Analyzing Cash Flow vs. Net Income: Guidelines

Compute the ratio of net income to cash flows from operating activities over multiple time
periods.

If the ratio is not close to 1, it could be due to a new accounting rule or recurring transactions,
or it could be a yellow flag.

A ratio above 1.5 means that more than half of the firm’s earnings are from non-cash or non-
operating.

A ratio below 0.5 could be caused by a non-cash or non-operating loss in the current period,
which might be legitimate or might be a manoeuvre used to create a reserve of earnings for a
future period.

A negative value for net income to cash flows from operating activities is also a yellow flag



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because it reveals a discrepancy between net income and CF from operating activities.




Yellow Flags in the Income statement: Guidelines

Overstated Income: understand how a company recognized revenue and compare it with its
peers as well as past practices.

Understated Expenses: COGS may be understated if switching from LIFO to FIFO or depleting
inventory.

To detect capitalizing too aggressively: Compare a firm’s practice to that of other firms in the
same sector, if a firm is the only one in its sector capitalizing a certain cost, the cost should
probably be expensed.

If there is enough detail provided by the company, look for an increase year-to-year in the
proportion of a particular cost a firm is capitalizing (instead of expensing).

Pension expense can be manipulated by changing certain assumptions: Raising the discount
rate or raising the estimated ROA.

Special charges should be scrutinized because management often has discretion which
facilitates earnings management (special charges: restructuring, m&a, impairment, tax
valuation) Calculate the ratio of tax valuation allowance to gross deferred tax assets:
Increases in this ratio warn that the firm thinks it will not generate enough profit to use its
tax benefits before they expire or it could be assign that management is using the allowance
as a reserve which it can use later to boost earnings.

Inventory valuation allowance due to excess inventory.

Allowance for doubtful accounts. This type of charge should be scrutinized unless it’s due to
one of the company’s large customers going bankrupt.



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When a company suddenly has a materially lower tax rate or consistently has a tax rate well
below its sectors peers.




YELLOW FLAGS ON BALANCE SHEET




Yellow Flags on the Balance Sheet: Guidelines

If either of the items below is more than 10% of a firm’s total assets: Goodwill, Deferred Tax
Assets.

Assets likely to generate less value: A/R: decreasing accounts receivable turnover ratio or
increasing days to collect. Inventory: look for evidence that inventory is selling more slowly-
decreasing inventory turnover ratio or increasing days to sell inventory.

Assets and liabilities with uncertain values: Question values based on level-three inputs much
more than those with level-one inputs.

Off balance sheet activities: If these were brought onto the balance sheet, they would
increase the company’s leverage: Operating leases, equity method investment, SPE.

Weak liquidity: Unless the firm has a negative cash cycle, values for the current ratio below
0.09 mean the firm’s current resources are no sufficiently large to pay its current liabilities.

Excess leverage: debt to equity or debt to total capital ratio much higher than sector peers is
a sign of a company that may be unable to cover is debt obligations. Average values vary by
sector, but generally a debt to equity ratio above 4 indicates high leverage and risk for a
commercial or industrial firm. This rule of thumb does not apply to financial services firms,
which are more highly leveraged.




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Times interest earned (earnings before interest and taxes/ interest expense): values below
2.0 warn that the firm may not generate sufficient profit to cover its interest costs.




YELLOW FLAGS IN CASH FLOW STATEMENT




Yellow Flags in the Cash Flow Statement: Guidelines

Primary source of cash and be large enough to fund growth and other discretionary spending.

Unless a firm is a start-up, negative net cash flows from operating activities are a yellow flag.

Common ways that firms can inflate cash flow from operating activities include:

     1) Delay paying bills: Look for a reduction in the payables turnover ratio or an increase in
        days payable.
     2) Postpone inventory replenishment until next period: look for a decrease in
        inventory/COGS.
     3) Securitize receivables: Look for a decrease in accounts receivable/sales.
     4) Sell Trading Securities: Look for a decrease in marketable securities/ total assets.
An unusually large increase in capex in one or more periods is usually indicative of growth
spending. Also divide capex by depreciation expense. Values in the 1.2 to 1.5 range are fairly
common for many industries indicating that the firm is spending for growth. Values near or
below 1 warn that the firm may not be spending enough to maintain current capacity. This
approach assumes that depreciation expense is reasonable estimate of the amount of
property, plant and equipment the firm must replace in order to maintain its current
productive capacity.

Be aware that for firms that use operating leases, CapEx is understated because the cash




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payment associated with operating leases are deducted from operating cash flows.




OTHER POTENTIAL YELLOW FLAGS


Other Potential Yellow Flags: Characteristics

Reduces the amount of information it discloses or discloses substantially less than its peers.
Management will defend its decision by saying it’s for competitive reasons.

If the company substantially changes the way it reports its results, make sure to dig deeply to
understand why, because it’s almost always to hide or downplay something.

Fails to mention that it’s benefiting from non operating profits in good quarters but is quick
to point out non-operating losses in bad quarters.

Takes special charges, write-offs, restates as though it’s an ongoing part of the business. If
any are more than 5%of the quarterly results, management should make a point of discussing
why the mistake occurred and steps that are being taken to ensure that it doesn’t happen
again.

Fails to discuss targets or hurdles for large investment projects.

Fails to discuss complicated or counterintuitive issues such as the thought process for M&A or
currency hedging.

Changes the manner in which corporate overhead expenses are allocated among its divisions.

Reports results much later than the competition.




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