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positively impacted by foreign exchange rates in 2003 by $253.2 million and $67.0
million in 2002 (International Division).

Here we see one of the benefits of a weaker U.S. dollar: it boosts the international
sales numbers of U.S. companies! In Office Depot's case, international sales were
boosted by $253 million because the dollar weakened over the year. Why? A weaker
dollar means more dollars are required to buy a foreign currency, but conversely, a
foreign currency is translated into more dollars. So, even though a product may
maintain its price in foreign currency terms, it will translate into a greater number of
dollars as the dollar weakens.

We call this a technical factor because it is a double-edged sword: if the U.S. dollar
strengthens, it will hurt international sales. Unless you are a currency expert and
mean to bet on the direction of the dollar, you probably want to treat this as a
random variable. The follow-up question to the currency factor is this: Does the
company hedge its foreign currency? (Office Depot generally does not, so it is
exposed to currency risk.)

Summary
Revenue recognition is a hot topic and the subject of much post-mortem analysis in
the wake of multiple high-profile restatements. We don't think you can directly guard
against fraud; that is the job of a company's auditor and the audit committee of the
board of directors. But you can do the following:

• Determine the degree of accounting risk posed by the company's business model.
• Compare growth in reported revenues to cash received from customers.
• Parse organic growth from the other sources, and be skeptical of any one-time
revenue gains not tied directly to cash (quality of revenues). Scrutinize any material
gains due to acquisitions. And finally, omit currency gains.



Working Capital (Balance Sheet: Current)

A recurring theme in this series is the importance of investors shaping their
analytical focus according to companies' business models. Especially when time is
limited, it's smart to tailor your emphasis so it's in line with the economic drivers


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that preoccupy the company's industry. It's tough to get ahead of the "investing
pack" if you are reacting to generic financial results--such as earnings per share
(EPS) or revenue growth--after they've already been reported. For any given
business, there usually are some key economic drivers, or leading indicators,that
capture and reflect operational performance and eventually translate into lagging
indicators such as EPS. For certain businesses, trends in the working capital accounts
can be among these key leading indicators of financial performance.

Where Is Working Capital Analysis Most Critical?
On the one hand, working capital is always of significance. This is especially true
from the lender's or creditor's perspective, where the main concern is defensiveness:
can the company meet its short-term obligations, such as paying vendor bills?

But from the perspective of equity valuation and the company's growth prospects,
working capital is more critical to some businesses than to others. At the risk of
oversimplifying, we could say that the models of these businesses are capital or
asset intensive rather than service or people intensive (examples of service intensive
companies are H&R Block, which provides personal tax services, and Manpower,
which provides employment services). In asset intensive sectors, firms such as
telecom and pharmaceutical companies invest heavily in fixed assets for the long
term, whereas others invest capital primarily to build and/or buy inventory. It is the
latter type of business--the type that is capital intensive with a focus on inventory
rather than fixed assets--that deserves the greatest attention when it comes to
working capital analysis. These businesses tend to involve retail, consumer goods,
and technology hardware (especially if they are low-cost producers or distributors).

Working capital is the difference between current assets and current liabilities:




Inventory
Inventory balances are significant because inventory cost accounting impacts
reported gross profit margins. For an explanation of how this happens, see
"Inventory Valuation For Investors: FIFO and LIFO." Investors tend to monitor gross
profit margins, which are often considered a measure of the value provided to
consumers and/or the company's "pricing power" in the industry. However, we
should be alert to how much gross profit margins depend on the inventory costing
method.

Below we compare three accounts--net sales, cost of goods sold (COGS), and the
LIFO reserve--used by three prominent retailers:



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Walgreen's represents our normal case and arguably shows the "best practice" in this
regard: the company uses LIFO inventory costing, and its LIFO reserve increases
year over year. In a period of rising prices, LIFO will assign higher prices to the
consumed inventory (cost of goods sold) and is therefore more conservative. Just as
COGS on the income statement tends to be higher under LIFO than under FIFO, the
inventory account on the balance sheet tends to be understated. For this reason,
companies using LIFO must disclose (usually in a footnote) a LIFO reserve, which
when added to the inventory balance as reported, gives the FIFO-equivalent
inventory balance.

As GAP Incorporated uses FIFO inventory costing, there is no need for a "LIFO
reserve." However, GAP's and Walgreen's gross profit margins are not
commensurable--that is, comparing FIFO to LIFO is not like comparing apples to
apples. GAP will get a slight upward bump to its gross profit margin because its
inventory method will tend to undercount the cost of goods. There is no automatic
solution for this. Rather, we can revise GAP's COGS (in dollar terms) if we make an
assumption about the inflation rate during the year. Specifically, if we assume that
the inflation rate for the inventory was R% during the year, and if "Inventory
Beginning" in the equation below equals the inventory balance under FIFO, then we
can re-estimate COGS under LIFO with the following equation:


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Kohl's Corporation uses LIFO, but its LIFO reserve declined year over year--from
$4.98 million to zero. This is known as LIFO liquidation or liquidation of LIFO layers,
and indicates that, during the fiscal year, Kohl's sold or liquidated inventory that was
held at the beginning of the year. When prices are rising, we know that inventory
held at the beginning of the year carries a lower cost (because it was purchased in
prior years). Cost of goods sold is therefore reduced, sometimes significantly.
Generally, in the case of a sharply declining LIFO reserve, we can assume that
reported profit margins are upwardly biased to the point of distortion.

Cash Conversion Cycle
The cash conversion cycle is a measure of working capital efficiency, often giving
valuable clues about the underlying health of a business. The cycle measures the
average number of days that working capital is invested in the operating cycle. It
starts by adding days inventory outstanding (DIO) to days sales outstanding (DSO).
This is because a company "invests" its cash to acquire/build inventory, but does not
collect cash until the inventory is sold and the accounts receivable are finally
collected.

Receivables are essentially loans extended to customers that consume working
capital; therefore, greater levels of DIO and DSO consume more working capital.
However, days payable outstanding (DPO)--which essentially represent loans from
vendors to the company--are subtracted to help offset working capital needs. In
summary, the cash conversion cycle is measured in days and equals DIO + DSO “
DPO:




Here we extracted two lines from Kohl's (a retail department store) most recent
income statement and a few lines from their working capital accounts.




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Circled in green are the accounts needed to calculate the cash conversion cycle.
From the income statement, you need net sales and COGS. From the balance sheet,
you need receivables, inventories, and payables. Below, we show the two-step
calculation. First, we calculate the three turnover ratios: receivables turnover
(sales/average receivables), inventory turnover (COGS/average inventory), and
payables turnover (purchases/average payables). The turnover ratios divide into an
average balance because the numerators (such as sales in the receivables turnover)
are flow measures over the entire year.

Also, for payables turnover, some use COGS/average payables. That's okay, but it's
slightly more accurate to divide average payables into purchases, which equals
COGS plus the increase in inventory over the year (inventory at end of year minus
inventory at beginning of the year). This is better because payables finance all of the
operating dollars spent during the period (that is, they are credit extended to the
company). And operating dollars, in addition to COGS, may be spent to increase
inventory levels.

The turnover ratios do not mean much in isolation; rather, they are used to compare
one company to another. But if you divide the turnover ratios into 365 (for example,
365/receivables turnover), you get the "days outstanding" numbers. Below, for
example, a receivable turnover of 9.6 becomes 38 days sales outstanding (DSO).
This number has more meaning; it means that, on average, Kohl's collects its
receivables in 38 days.




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Here is a graphic summary of Kohl's cash conversion cycle for 2003. On average,
working capital spent 92 days in Kohl's operating cycle:




Let's contrast Kohl's with Limited Brands. Below we perform the same calculations in
order to determine the cash conversion cycle for Limited Brands:




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While Kohl's cycle is 92 days, Limited Brand's cycle is only 37. Why does this matter?
Because working capital must be financed somehow, with either debt or equity, and
both companies use debt. Kohl's cost of sales (COGS) is about $6.887 billion per
year, or almost $18.9 million per day ($6.887 billion/365 days). Because Kohl's cycle
is 92 days, it must finance--that is, fund its working capital needs--to the tune of
about $1.7+ billion per year ($18.9 million x 92 days). If interest on its debt is 5%,
then the cost of this financing is about $86.8 million ($1.7 billion x 5%) per year.
However, if, hypothetically, Kohl's were able to reduce its cash conversion cycle to
37 days--the length of Limited Brands' cycle--its cost of financing would drop to



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about $35 million ($18.9 million per day x 37 days x 5%) per year. In this way, a
reduction in the cash conversion cycle drops directly to the bottom line.

But even better, the year over year trend in the cash conversion cycle often serves
as a sign of business health or deterioration. Declining DSO means customers are
paying sooner; conversely, increasing DSO could mean the company is using credit
to push product. A declining DIO signifies that inventory is moving out rather than
"piling up." Finally, some analysts believe that an increasing DPO is a signal of
increasing economic leverage in the marketplace. The textbook examples here are
Wal-mart and Dell: these companies can basically dictate the terms of their
relationships to their vendors and, in the process, extend their days payable (DPO).

Looking "Under the Hood" for Other Items
Most of the other working capital accounts are straightforward, especially the current
liabilities side of the balance sheet. But you do want to be on the alert for the
following:

• Off-balance sheet financing.
• Derivatives.

For examples of these two items, consider the current assets section of Delta
Airlines' fiscal year 2003 balance sheet:




Notice that Delta's receivables more than doubled from 2002 to 2003. Is this a

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