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Balance Sheet Analysis. Alexander Motola, CFA. Quality of Earnings, Chapter 8 Two Key Ratios: Accounts Receivable and Inventories.

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balance sheet analysis

Balance Sheet Analysis

Alexander Motola, CFA

Alexander Motola, 2013

quality of earnings chapter 8 two key ratios accounts receivable and inventories
Quality of Earnings, Chapter 8Two Key Ratios: Accounts Receivable and Inventories

“…the best method I have ever discovered to predict future downwards earnings revisions by Wall Street security analysts – is a careful analysis of accounts receivable and inventories.” (QoE, pg. 107)

  • Was is predicting future downwards earnings revisions important?
  • Is A/R and inventory analysis difficult?

Alexander Motola, 2013

quality of earnings ch 8
Quality of Earnings, Ch. 8
  • All of the examples are 30 years old – are they still relevant today?
    • Those business are (largely) gone
    • Mgmt and investor psychology remain
    • Accounting standards have evolved, but not too much
    • 2000-2002 market “event” was a repeat of the 1984-1985 debaucle

Alexander Motola, 2013

quality of earnings ch 81
Quality of Earnings, Ch. 8
  • In most financial analysis, we are less concerned with the absolute (actual) numbers, and more concern with the change in the pattern
    • You need a lot of data
      • Many periods of numbers
      • Competitor/Industry data where applicable
    • You need to understand what the numbers mean, and how they might be derived

Alexander Motola, 2013

accounts receivable
Accounts Receivable
  • Companies sell goods to customers– this is revenue
  • Customers either pay cash or use credit (usually 30 days)
  • If the customers don’t pay at the time of the transaction (revenue), then A/R is created
  • Credit is a normal part of business; it removes a transactional barrier
  • What can we learn from credit?

Alexander Motola, 2013

accounts receivable1
Accounts Receivable
  • Think about your job – what does your company do? How soon do customers pay?
  • There is normally an “appropriate” amount of credit, relative to sales, for most businesses
  • Calculations
    • EOP (easiest): AR/Rev*#days
    • AVE: [(Current period AR + Last Period AR)/2]/Rev*#ofdays (91.25)
    • 4Q Average: (5 AR [ave])/cumulative sales * #days

Alexander Motola, 2013

accounts receivable2
Accounts Receivable
  • What A/R is on the balance sheet?
    • What does “Net” mean?
    • What does “Gross” mean?
    • What is ADA?
    • Which # makes more sense, Net or Gross?
    • If Wall Street focuses on Net A/R, what does that mean?

Alexander Motola, 2013

accounts receivable3
Accounts Receivable
  • What is a “DSO”?
    • It is an average
    • It approximates the number of days – on average – that it takes a company to turn a sale (revenue) into cash
    • Lower is better, but it depends on the business cycle
    • The faster you grow, the more working capital you need…

Alexander Motola, 2013

accounts receivable4
Accounts Receivable
  • I like Gross
    • It *IS* the amount of money owed the company
    • The reserve does matter, it is estimated by the company based on their “experience”
      • If the reserve changes a lot, either the company is manipulating earnings, A/R, or their “experience” has changed – any one of these are important

Alexander Motola, 2013

accounts receivable5
Accounts Receivable
  • Allowance for Doubtful Accounts
  • Look at the trend
    • It’s not seasonal
    • It probably impacted A/R, DSO, and EPS

Alexander Motola, 2013

accounts receivable6
Accounts Receivable
  • Example of ADA T-Account
    • You can see the income statement impact

Alexander Motola, 2013

accounts receivable7
Accounts Receivable
  • DSO trend - ramps suddenly
  • Why are DSOs up?
    • Economy weakening
    • Regulatory changes
    • More credit extension – financing customers, channel stuffing, stealing from future revenues
    • Customers can’t/won’t pay

Alexander Motola, 2013

accounts receivable8
Accounts Receivable
  • Some companies will disclose their “Aging” in a footnote
  • Aging is more detail of the total A/R by different buckets based on how long “past due” or current they are
  • Sometimes just a few customers skew the DSO upwards because they can’t or won’t pay
  • Companies HAVE to disclose if they have 1 or more customers that make up 10%+ of sales or A/R in any reported period

Alexander Motola, 2013

accounts receivable9
Accounts Receivable
  • The dirty little secret – Factoring
  • Ramping DSO is seen as a collection issue, analysts understand earnings quality declines as DSO goes up
  • Companies can sell A/R to finance companies for X cents on the dollar
    • A/R down
    • Cash up
    • No tell tale on the SCF, either
    • It’s no economic for most companies, it’s purely cosmetic, and comes at a cost

Alexander Motola, 2013

accounts receivable10
Accounts Receivable
  • Is there a way to discover if a company is factoring?
    • Not really
    • Most companies will tell you if you ask
    • You can delve into their banking relationships, but you aren’t likely to get very far
  • If you want to learn more, a good next step is to read either
    • What’s Behind the Numbers? Del Vecchio and Jacobs
    • Financial Shenanigans – Schilit

Alexander Motola, 2013

inventory
Inventory
  • This reflects the value add created by the company on the balance sheet at the product level
  • It is a direct input into COGS
  • Should a company have a lot of inventory?
  • What questions should we ask about a company’s inventory?

Alexander Motola, 2013

inventory1
Inventory
  • Like A/R, we can look at the absolute level as well as the amount of inventory relative to sales
  • “Relative to sales” means DIO
    • Days of Inventory Outstanding
    • Is it really relative to Sales/Revenues?
    • Basic calculation is: Inv/COGS*#days
      • Why?
    • What does DIO tell us as analysts?

Alexander Motola, 2013

inventory2
Inventory
  • Most companies report 3 “buckets” of inventory
    • Raw Materials
    • WIP (Work in Progress)
    • Finished Goods
    • It obviously depends on the business model

Alexander Motola, 2013

inventory3
Inventory
  • Here’s an example of a footnote
    • All three categories are there
    • They also have the LIFO/FIFO adj

Alexander Motola, 2013

inventory4
Inventory
  • What does a lot of Finished Goods tell us (as a mix of inventory)?
  • What does a lot of Raw Materials tell us?
  • These are both examples which would cause Inventory $ and DIOs to go up, but the conclusions are different…

Alexander Motola, 2013

inventory5
Inventory
  • DIO example
  • ONNN has a long history of DIO around 80 days
  • But then there’s this move of +40 days
    • Big acquisition (SANYO)
    • Not really worrying if they can “work it down”

Alexander Motola, 2013

inventory6
Inventory
  • DIO example
  • ONNN has a long history of DIO around 80 days
  • But then there’s this move of +40 days
    • Big acquisition (SANYO)
    • Not really worrying if they can “work it down” – which they were obviously able to do

Alexander Motola, 2013

inventory7
Inventory
  • DIO example
  • ONNN has a long history of DIO around 80 days
  • But then there’s this move of +40 days
    • Big acquisition (AMI Semi)
    • Not really worrying if they can “work it down” – which they were obviously able to do

Alexander Motola, 2013

inventory8
Inventory
  • Sometimes there is just a problem…
  • UTSI grew > 75% each of the first two quarters of 2003…
  • Having accelerated from the previous year (around the 30-40% range)
  • With the help of some acquisitions…
  • And the stock had been awesome as the revenue acceleration happened

Alexander Motola, 2013

inventory9
Inventory

Alexander Motola, 2013

inventory10
Inventory
  • Inventories go nuts, up to $1b in 2Q03, equating to 374 days
  • The inventories come down, but we later learn they’ve tried to move them “OBS” (the # in row 264).
  • UTSI – after clearing mgmt house – conducted a series of self investigations regarding their accounting and business practices, and much mischief was found

Alexander Motola, 2013

inventory11
Inventory

Alexander Motola, 2013

other cookie jars
Other “Cookie Jars”
  • “A disingenuous accounting practice in which periods of good financial results are used to create reserves that shore up profits in lean years. “Cookie jar accounting” is used by a company to smooth out volatility in its financial results, thus giving investors the misleading impression that it is consistently meeting earnings targets.” - Investopedia
  • You can analyze DDR, or days of deferred revenue, on a similar basis
  • Warranties are another place to store expenses

Alexander Motola, 2013

other cookie jars1
Other “Cookie Jars”

“One of the best-known cases of cookie jar accounting in recent years was that of computer giant Dell, which in July 2010 agreed to pay a $100 million penalty to the Securities and Exchange Commission (SEC) to settle SEC allegations that it used cookie jar reserves. The SEC maintained that Dell would have missed analysts’ earnings estimates in every quarter between 2002 and 2006 had it not dipped into these reserves to cover shortfalls in its operating results. The cookie jar reserves were created through undisclosed payments that Dell received from chip giant Intel in return for agreeing to use Intel’s CPU chips exclusively in its computers. (Intel made these payments to Dell to lock out rival chipmaker Advanced Micro Devices from Dell computers.)” - Investopedia

Alexander Motola, 2013

summary
Summary
  • Earnings (EPS) isn’t just a number – you need to evaluate what’s behind it
  • Most of the information necessary to determine Earnings Quality is available
  • The larger your sample (more periods), the more insightful you can be
  • Everything has context; the numbers are clues, but you still need to piece together what they are saying

Alexander Motola, 2013