S3 Learning Notes For Module 2

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FINANCIAL STATEMENT ANALYSIS

THE ADVANCED FINANCIAL STATMEENT ANALYSIS
MODULE 2: OPERATING EFFICIENCY ASSESSMENT
LEARNING MATERIAL – TAKEAWAY NOTE
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What is Operating Efficiency?

 Operating efficiency is how well a company’s management
makes use of its cash and other assets.
 The majority of the associated ratios address cash, from actual
cash on hand to cash inputs or outputs like AR and AP.
 Others measure management of inventory or use of fixed and
total assets.
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Operating Efficiency Ratios

 We will use twelve ratios to measure operating efficiency:
 Cash Turnover  Accounts Payable Turnover
 Days Cash on Hand  Days Payables Outstanding
 Inventory Turnover  Working Capital Turnover
 Days Inventory Outstanding  Days Working Capital
 Accounts Receivable Turnover  Fixed Asset Turnover
 Days Sales Outstanding  Total Asset Turnover
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Cash Turnover Ratio - In a Nutshell

 The cash turnover ratio is a measure of cash usage efficiency and
of the amount of cash needed for revenue generation.
 While it can be used by investors to analyze a company’s
performance, it is more commonly used by management to
assess cash requirements to increase sales.
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Formula & Calculation
Annual Revenue
Cash Turnover Ratio =
Average Cash Balance
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Real-world Examples
Apple, Inc. (AAPL) Microsoft (MSFT) Oracle Corp. (ORCL)
Revenue $215.64 billion $85.32 billion $37.05 billion
Avg. Cash Balance $20.80 billion $6.05 billion $20.93 billion
Cash Turnover
10.37 14.10 1.77
Ratio
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Further Explanation
 It is very important to understand that the cash turnover ratio is
easily distorted.
 A company that pays out dividends will have less cash on hand
than a similar company that does not pay dividends, making the
ratio higher.
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Further Explanation
 A company that sells extensively on credit will have a higher ratio
than a company that does not since it will have less cash relative
to revenue, with the balance sitting in accounts receivable.
 When analyzing a company as an investment prospect, you
would do better to look at how the company uses its cash, not
just this ratio.
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Things to Take Away!

 Key points for this ratio:
 Measures cash usage efficiency and, for management, how
much cash is needed to generate a given amount of revenue
 “Cash and cash equivalents” used in the ratio normally
includes marketable securities as well since companies
usually avoid leaving cash sitting completely idle
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 Both revenue and average cash on hand must be determined
for the period being examined (fiscal year, quarter, etc.)
 Formula inputs come from income statement and cash flow
statement
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 The ratio is easily distorted by such factors as paying
dividends, buying back stock, or granting credit to customers
 The ratio is less useful than a careful examination of the cash
flow statement
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Days Cash on Hand - In a Nutshell

 Days cash on hand is not a ratio, but rather a number indicating
exactly what the name says: how many days the company can pay
its current operating expenses before running out of money.
 This measurement is more commonly used by management,
especially for startup companies, but outside analysts do use it as
a rough indicator when evaluating a company’s financial health.
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Cash and Cash Equivalents

Days Cash on Hand =
(Operating Expenses – Noncash Expenses) ÷ 365
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Real-world Examples
Darden Restaurants, Brinker International, Hyatt Hotels Corp.
Inc. (DRI) Inc. (EAT) (H)
Cash/Cash Equiv. $275M $31M $482M
Operating Exp. $6.31B $2.94B $4.13B
Noncash Exp. $292M $156M $342M
DCOH 16.68 4.06 46.44
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Further Explanation
 Also, even for companies that do have revenue challenges, DCOH
is not a perfect measure.
 When a company runs into cash flow problems, the first thing
management does is cut costs—sometimes drastically.
 It’s more informative for management to look at the actual cash
flow cycle rather than taking the DCOH number at face value.
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 Provides a rough indicator of how long the company could
operate using its existing cash on hand
 Calculated using cash and cash equivalents and actual cash
expenses
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 Not very useful for currently-operating companies because it
ignores cash inflows from revenue
 More useful to management, and even then only for startups
or companies with a seasonal or temporary revenue
disruption
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Inventory Turnover Ratio - In a Nutshell

 The inventory turnover ratio is a calculation of how many times a
company sells and replaces its inventory in a given time period.
 The output of the formula can be used to calculate how many
days this process takes.
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Total Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory
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Real-world Examples
National Beverage Monster Beverage The Coca-Cola Co.
Corp. (FIZZ) Corp. (MNST) (KO)
Total COGS $463M $1.15B $16.46B
Inventory TY $29M $103M $844M
Inventory LY $25M $104M $1.03B
Avg. Inventory $27M $103.5M $938M
Inventory
17.15 11.11 17.55
Turnover Ratio
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Further Explanation
 The Inventory Turnover Ratio number itself in isolation has only
limited usefulness. If inventory turns too fast, it means the
company may be unable to keep up with demand.
 Converting the ITR into days is helpful in this regard, but some
knowledge of the industry is needed, so what constitutes “too
fast” is very industry-specific.
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 Calculated using Cost of Goods Sold and average inventory for
the period.
 Can be used to calculate how many days a company takes to
completely turn its inventory by dividing the number of days
in the period under consideration by the ITR.
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 Inventory Turnover Ratio is most useful when analyzed as a
trend and/or in comparison to peers and industry average
 Should be calculated using sales instead of Cost of Goods Sold
only as a last resort, and then only for relative comparisons of
companies
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Days Inventory Outstanding - In a Nutshell

 The days inventory outstanding measure, also referred to as days
sales of inventory or days in inventory, is an assessment of how
quickly a company can convert inventory to sales.
 It also shows quite literally how many days of sales can be
supported by the inventory the company has on hand.
 Its role is to assess how long cash is tied up as inventory.
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Average Inventory
Days Inventory Outstanding = × 365
Cost of Goods Sold
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Real-world Examples
General Mills, Inc.
Kellogg Co. (K) Hershey Co. (HSY)
(GIS)
Total COGS $10.71B $7.93B $4.28B
Inventory TY $1.41B $1.24B $746M
Inventory LY $1.54B $1.25B $751M
Avg. Inventory $1.475B $1.245B $748.5M
Days Inventory
50.27 57.30 63.80
Outstanding
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Further Explanation
 Be careful about confusing the inventory turn ratio with Days
Inventory Outstanding.
 While a higher ITR is better, in general a lower Days Inventory
Outstanding is preferable.
 A high ITR and a low DIO both point to the same thing: the
company sells its inventory quickly.
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 Days Inventory Outstanding is the first of three measures that
calculate a company’s cash conversion cycle. It assesses how
long a company keeps cash tied up as inventory
 The DIO formula uses work in progress and raw materials as
well as finished goods when calculating inventory
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 Days Inventory Outstanding should only be used within the
same industry segment since not all companies maintain a stock
of raw materials
 Generally speaking, a low Days Inventory Outstanding number is
better
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Accounts Receivable Turnover Ratio - In a Nutshell

 The accounts receivable turnover ratio is a measure of how
quickly a company is able to collect receivables from customers.
 It compares the average accounts receivable balance to the total
net credit sales.
 It is a liquidity measure, since it indicates how quickly a company
converts receivables to cash.
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Net Credit Sales

A/R Turnover Ratio =
Avg. Accounts Receivable Balance
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Real-world Examples
General Electric Co. 3M Co. Siemens AG

(GE) (MMM) (SIEGY)
Net Credit Sales Unknown $28.501B Unknown
Avg. A/R Balance $25.549B $4.273B $14.095B
ARTR Unknown 6.67 Unknown
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 Indicates how many times a company turns its average
Accounts Receivable balance within the period
 Can be used to calculate how many days the company takes
to collect its receivables
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 Net credit sales can be very difficult to find for public
companies; you will normally have to review the management
discussion and analysis in the annual report
 In some cases, the annual report may specify the Accounts
Receivable Turnover Ratio itself
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Days Sales Outstanding - In a Nutshell

 The days sales outstanding (DSO) indicates how many days a
company takes to receive cash after a sale is made.
 This ratio is the second of three components of the cash
conversion cycle.
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Avg. A/𝑅
Days Sales Outstanding = × Days in Period
Net Credit Sales
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Real-world Examples
3M Co. (MMM)
Net Credit Sales $28.501B
Avg. A/R Balance $4.273B
Days Sales Outstanding 54.72
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Further Explanation
 A Days Sales Outstanding under 45 is viewed as quite good. A DSO
around 60 is fairly typical.
 If the DSO is reaching closer to 90, it is a sign of financial trouble.
 The trend over time is more important than any single snapshot in
time. An unusually low DSO (compared to industry peers) is normally
a negative.
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 Calculates how many days on average a company takes to
collect its receivables
 Since it is the converse of the ARTR, a low number is better
and indicates that the company receives its money more
quickly
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 As with ARTR, net credit sales can be very difficult to
determine from publicly-reported data
 While industries vary, a DSO of 45 is good and 60 is average
 An unusually low DSO is a negative indicator, as it means the
company’s credit policies are probably costing it sales
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Accounts Payable Turnover Ratio - In a Nutshell

 The accounts payable turnover ratio (APTR) is an assessment of
liquidity, although instead of looking at long-term debt, it
measures how quickly a company pays its vendors.
 The ratio calculates the number of times the company pays off
its total average accounts payable balance during the course of
the period.
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Total Purchases
A/P Turnover Ratio =
Avg. Accounts Payable Balance
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Real-world Examples
International Paper Avery Dennison Corp. Sealed Air Corp.

Co. (IP) (AVY) (SEE)
Total Purchases $15.362B $4.427B $4.043B
Avg. A/P Balance $2.1935B $828.5M $607M
APTR 7.00 5.34 6.66
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 Calculates how many times a company pays its average
Accounts Payable balance in a given period
 Total purchases will not appear in the financial statements
and so must be calculated
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 Does not address all accounts payable, but only those
associated with COGS
 Can be used to calculate the length of the company’s average
payables cycle. Nonexistent for companies that do not
maintain an inventory of physical goods.
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Days Payable Outstanding - In a Nutshell

 The Days Payable Outstanding calculation shows how many days
a company takes to pay its vendors.
 DPO is the third and final component of the cash conversion
cycle, which begins when a company purchases raw materials or
inventory and ends when it pays for those purchases using cash
collected from customers.
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Avg. A/P balance

Days Payable Outstanding = ×Days in Period
Cost of Goods Sold
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Real-world Examples
International Avery Dennison Corp. Sealed Air Corp.

Paper Co. (IP) (AVY) (SEE)
Total COGS $15.152B $4.387B $4.247B
Avg. A/P Balance $2.1935B $828.5M $607M
Days Payable
52.84 68.93 52.17
Outstanding
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Further Explanation
 APTR cannot be calculated for companies that do not hold
physical inventories, so for the most part the same will hold true
with DPO.
 It is possible to determine DPO even when APTR cannot be
directly ascertained.
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 Indicates how many days on average a company takes to pay
its vendors
 Is the third and final component of the cash conversion cycle
 APTR can be used to calculate DPO, and conversely DPO can
be used to “back into” APTR
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 Can be calculated for more companies than Accounts Payable
Turnover Ratio because even those that produce intangible
goods often show a cost of sales or cost of revenue line item,
which can substitute for COGS
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Working Capital Turnover Ratio - In a Nutshell

 The working capital turnover ratio (WCTR) is a measure of
management effectiveness.
 It assesses how much revenue is generated by each dollar of
working capital.
 Excessive accounts receivable and/or excessive inventory have a
negative impact on WCTR.
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Sales
Working Capital Turnover Ratio =
Average Working Capital
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Real-world Examples
Winnebago Ind., Sturm Ruger & Co.

Mattel, Inc. (MAT)
Inc. (WGO) (RGR)
Avg. Working Capital $1.3945 billion $186 million $120.5 million
Sales $5.457 billion $975 million $664 million
WCTR 3.91 5.24 5.51
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Real-world Examples
Spiral Toys, Inc. (STOY)
Avg. Working Capital $70,000
Sales $5.96 million
WCTR 85.14
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Real-world Examples
Amazon (AMZN)
Avg. Working Capital $136 billion
Sales $1.8915 million
WCTR 71.89
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 Measures how efficiently a company uses its working capital
to generate sales
 Higher is better, but an extremely high ratio (above 20) is a
red flag
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 It is important to compare Working Capital Turnover Ratio
only among industry peers
 Look closely at the underlying numbers to see exactly why a
company has a high Working Capital Turnover Ratio
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Days Working Capital - In a Nutshell

 Days working capital measures how much money a company has
to fund its operations, measured in days.
 It is a measure of efficiency and of liquidity as well.
 This is the companion measurement to the working capital
turnover ratio.
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(Avg. WC × Days in Period)

Days Working Capital =
Period Sales
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Real-world Examples
Winnebago Ind., Inc. Sturm Ruger & Co.

Mattel, Inc. (MAT)
(WGO) (RGR)
Avg. Working Capital $1.3945 billion $186 million $120.5 million

Sales $5.457 billion $975 million $664 million
Days Working Capital 93.27 69.63 66.24
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Further Explanation
 Numbers at either extreme - too high or too low - tend to be
negative.
 DWC can also be negatively impacted by underleveraging.
 If a company takes on long-term debt, the current assets
increase, but the current liabilities do not. This will cause DWC to
increase.
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Fixed Asset Turnover Ratio - In a Nutshell

 The fixed asset turnover ratio is an efficiency measure that looks
at how much revenue a company produces with its fixed assets.
 It is also a critical measure because it shows how easily a
company can pay for expensive fixed asset investments.
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Net Sales
Fixed Asset Turnover Ratio =
Avg. NBV of Fixed Assets
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Real-world Examples
Caterpillar, Inc. Navistar Int. Corp.

Deere & Co. (DE)
(CAT) (NAV)
Fixed Assets-NBV (Avg.) $10.612 billion $15.706 billion $1.293 billion
Net Sales $26.644 billion $38.537 billion $8.111 billion
Fixed Asset Turnover

2.51 2.45 6.27
Ratio
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Further Explanation
 It is important to examine the underlying data to detect factors
that can distort FATR.
 Look carefully to determine what method of depreciation the
company is using, as accelerated depreciation will cause NBV to
decline more rapidly and artificially improve FATR.
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 Measures how efficiently a company generates revenue with
its fixed assets
 Based on depreciated (net book) value of the assets, and best
calculated using average NBV for the period
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 Differences even among companies in the same industry can
skew the FATR
 Look at the FATR trend over time and see whether changes in
business model or lack of investment in new assets is causing
the ratio to improve
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 Calculates how many days of operations the company can
fund with its working capital
 Either extreme—high or low—of DWC is a red flag
 Make peer-to-peer comparisons and consider trends and
underlying data; don’t simply take the number at face value
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Total Asset Turnover Ratio - In a Nutshell

 The total asset turnover ratio (TATR) is similar to the fixed asset
turnover ratio (FATR), but it is broader in scope as it considers all
assets.
 The TATR is applicable to far more companies since it includes
intangible assets such as intellectual property, which are far more
important in some industries than fixed assets.
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Net Sales
Total Asset Turnover Ratio =
Average Total Assets
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Real-world Examples
Caterpillar, Inc. Navistar Int. Corp.
Deere & Co. (DE)
(CAT) (NAV)
Total Assets (Avg.) $57.9645 billion $76.523 billion $6.151 billion
Net Sales $26.644 billion $38.537 billion $8.111 billion
TATR 0.46 0.50 1.32
FATR (for reference) 2.51 2.45 6.27
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 Uses the same rationale as Fixed Asset Turnover Ratio but is
based on the total value of all of a company’s assets
 Not limited to physical asset-intensive industries as Fixed
Asset Turnover Ratio is
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 Because it is broader, is also more subject to distortion by
balance sheet items not common to all companies being
compared
 Still valid only for comparisons of companies with similar
business models
WHAT YOU WILL LEARN?
• Fully Develop a Successful Entrepreneurial Mindset (Most Important)
• What does really mean ‘doing business’?
THANK YOU FOR READING!
• Create Multiple Streams of Income
• How to Start a Business Effectively
• Master in Using the Power of Leverage
• How to Build a Successful Business Plan

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FINANCIAL STATEMENT ANALYSIS

What is Operating Efficiency?

Operating Efficiency Ratios

Cash Turnover Ratio - In a Nutshell

Formula & Calculation

Apple, Inc. (AAPL) Microsoft (MSFT) Oracle Corp. (ORCL)

Revenue $215.64 billion $85.32 billion $37.05 billion

Avg. Cash Balance $20.80 billion $6.05 billion $20.93 billion

Things to Take Away!

Things to Take Away!

Things to Take Away!

Days Cash on Hand - In a Nutshell

Formula & Calculation

Cash and Cash Equivalents

Cash/Cash Equiv. $275M $31M $482M

Operating Exp. $6.31B $2.94B $4.13B

Noncash Exp. $292M $156M $342M

DCOH 16.68 4.06 46.44

Things to Take Away!

Things to Take Away!

Inventory Turnover Ratio - In a Nutshell

Formula & Calculation

Total Cost of Goods Sold

Total COGS $463M $1.15B $16.46B

Inventory TY $29M $103M $844M

Inventory LY $25M $104M $1.03B

Avg. Inventory $27M $103.5M $938M

Things to Take Away!

Things to Take Away!

Days Inventory Outstanding - In a Nutshell

Formula & Calculation

Total COGS $10.71B $7.93B $4.28B

Inventory TY $1.41B $1.24B $746M

Inventory LY $1.54B $1.25B $751M

Avg. Inventory $1.475B $1.245B $748.5M

Things to Take Away!

Things to Take Away!

Accounts Receivable Turnover Ratio - In a Nutshell

Formula & Calculation

Net Credit Sales

General Electric Co. 3M Co. Siemens AG

Net Credit Sales Unknown $28.501B Unknown

Avg. A/R Balance $25.549B $4.273B $14.095B

ARTR Unknown 6.67 Unknown

Things to Take Away!

Things to Take Away!

Days Sales Outstanding - In a Nutshell

Formula & Calculation

Net Credit Sales $28.501B

Avg. A/R Balance $4.273B

Days Sales Outstanding 54.72

Things to Take Away!

Things to Take Away!

Accounts Payable Turnover Ratio - In a Nutshell

Formula & Calculation

International Paper Avery Dennison Corp. Sealed Air Corp.

Total Purchases $15.362B $4.427B $4.043B

Avg. A/P Balance $2.1935B $828.5M $607M

APTR 7.00 5.34 6.66

Things to Take Away!

Things to Take Away!

Days Payable Outstanding - In a Nutshell