Guru Mantra 16- Competitive Advantage: Racing for Uniqueness (The Second Part)

Financial Analytics- Efficiency; measuring outputs against input

It’s a performance indicator involves human and machine alike. A relationship of output against inputs. This also indicates drop outs or waste in the process. The genesis of efficiency comes from economic efficiency which is a state where resource is rationally allocated so that maximum benefit can be derived. The economic efficiency exhibits management standard on capital allocation including cost of funding, production efficiency with technology attached thereof and more importantly directing efficiency where it’s required.

Summary will be efficiency is a measurement of effectiveness to identify man and machine required to produce competitive goods and services.

Financially efficiency focus on key operational numbers i.e. sales, inventory and vendors. Also, fixed asset as engine of growth. So, we come straight to the ratios now:

  1. Receivables turnover and days sales outstanding
  2. Inventory turnover and days inventory
  3. Payables period
  4. Fixed Asset and total asset turnover
  5. Cash conversion cycle

Receivables turnover and days sales outstanding

Credit management of customers, how often you will give them credit? What would be period of credit? How does credit cost factor in pricing? What is the amount of credit you should allow?
So, we divide credit sales (sale made on credit) by accounts receivable (average of opening plus closing by two is more acceptable as it smooths out period) to get receivables turnover. Days sales outstanding is how many days company sales are outstanding or yet to be collected?

What does it tell us then? This is what I look for:

a. If the gross margin is say 2% and credit period is 90 days I have an issue with management lending below risk free return. But selective customers at 90 days something require a different eye.
b. If days sales outstanding goes down year after year it would mean management is collecting money faster.
c. If days sales outstanding are smaller than competitors it may tell a story that customer is ready pay quicker to my company and this may be due to superior product quality.

What it doesn’t tell us?

a. At end of day accounting is a number, if I clean up bad debts from receivables the base would come down and ratio will improve. But writing off bad debts regularly is scary.
b. The numbers are for a day i.e. balance sheet date. It can vary dramatically within period.
c. Related party transactions can distort any ratio, you use faster credit period for related parties. It averages out slowness of other customers.

Nevertheless, how does it will look for five company categories:

Cat 1: this would be mostly same for all ratios. Internally improving ratio YOY and with peers.
Cat 2: selective credit management are likely, I recalculate ratios after removing related party transactions if any and all other extended known credit period transactions.
Cat 3: every Blue Ocean company activities are linked to value innovation. Ratios are meaningless for this category.
Cat 4: Check write offs and clean ups. If credit is extended margin may be have been expanded, check for divergence.

For categories of company and Blue Ocean please see posts above.

Inventory turnover and days inventory outstanding

Calculations are same like receivables turnover, of course we use the inventory number as denominator and cost of goods sold ad numerator.

What does it tell us then? This is what I look for:

a. Purchase and sales are directly linked here. If you make high purchase you have to sell it equally high or else inventory turnover just deteriorate.
b. For lower inventory turnover, I check associated costs though it would be difficult for a retail shareholder to know carrying and storage cost. Yet look out for abnormal number if disclosed.
c. Margin analysis is one major key driver behind all efficiency ratios. Either I have high inventory turnover and low margin or low inventory turnover and high margin.
d. Purchase price symmetry with inventory levels. Low inventory turnover ratio where inventory prices are increasing is good where as decreasing inventory prices can be painful. This is a regular problem for commodity and cyclical companies where prices are decided on a market place which includes an element of speculation.

What it doesn’t tell us?

a. Just in time inventory concept or low inventory levels are good as long as we don’t know the opportunity costs of sales foregone. Losing revenue and customer without inventory can jeopardise the future of company.
b. Remove obsolete inventory and your ratio looks healthy. Once again obsolete inventory on a regular basis demonstrate inefficiency.
c. We have same average period problem, it’s a number on reporting date.

Categories stacking up

Cat 1: same as receivables turnover.
Cat 2: there could be high level of inventory, one way is to see consistency. If story is same over 10 years period you may have an issue.
Cat 3: same as receivables turnover except focussed Blue Oceans may have huge inventory build-up for cracking an idea out of the box.
Cat 4: same as receivables turnover.

Payables period and days purchase outstanding

Calculations are same like inventory turnover, instead of inventory use purchase numbers,

What does it tell us then? This is what I look for:

a. In conjunction with inventory turnover and receivables turnover- if my customer doesn’t pay and I can’t sale the goods faster I would delay payment to vendors. :blush:
b. Vendor payment period is higher than customer credit period if available.
c. Link with amount of purchases you made, delayed payment period may come with high prices charged by vendor.

What it doesn’t tell us?

a. Statutory charges and insurance like stuffs would have gone through vendor management system and faster the payment cycle. But in reality, you don’t have choice there, can you delay tax payment?
b. Payments withheld due to large defective products purchased.
c. Cash purchases outside the vendor master and charged off as below the line item. Meaning not debited to cost of goods sold.

Categories stacking up

Cat 1: same as receivables turnover.
Cat 2: same as inventory turnover.
Cat 3: same as inventory turnover, some vendors may be funded by Blue Ocean companies. These varieties worked on strategic partnership model to build a concept or innovation.
Cat 4: same as receivables turnover.

Cash conversion cycle-CCC

Days inventory outstanding PLUS Days sales outstanding MINUS days purchase outstanding
Summation of payables, receivables and inventory. How effectively management is using one account against other. Example if I collect late then I can pay late and improve my liquidity. Or if I have sales return I send them back to vendor if I can.

Few points:

  1. If a company does not deal with inventory it becomes a comparison of purchase and sales. But issue happens say like IT companies where purchase is not significant cost rather its human cost.
  2. CCC period against gross margin should be healthy. More sensitive if you have cash credit or loan against working capital.
  3. Improved CCC on vendor strength could be temporary, consistency is important to demonstrate.
    CCC you can define also as TIME FOR INFLOWS MINUS TIME TO OUTFLOWS
    Note- you can read details further on internet. Not trying to repeat academic stuffs a lot here other than bare necessity.

Fixed and Total Asset Turnover

Net sales to fixed asset for Fixed asset turnover where as net sales to total asset for total asset turnover. A gauge to understand how efficiently assets are used to make money.

Points to note:

  1. Do not use in industries like IT or financial services. They won’t have much tangible asset.
  2. Do keep an eye on sale of fixed asset, unproductive asset sales are good but not forced selling of productive assets.
  3. Financing of fixed asset has a lot to do, if I have soft financing I can go slow in targeting a higher turnover ratio to accommodate customer demand and margin.
  4. Depreciation itself is a confusing interpretation, Income tax and companies act themselves do not agree.
  5. Total asset turnover includes entire asset side of balance sheet which can include purchased goodwill which is meaningless sunk cost at times.

I would stop here, you let me know if you have questions. A number of boarders can address.

Happy investing guys!

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