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example, the business “turns” its customers™ receivables a lit-
tle more than 10 times a year, which indicates that it waits
about a tenth of a year on average to collect its receivables
from credit sales. This appears reasonable, assuming that
the business extends one-month credit to its customers. (A
turnover of 12 would be even better.)


Inventory Turnover Ratio
In the business example, the company sells products. Virtually
every company that sells products carries an inventory, or
stockpile of products, for a period of time before the products
are sold and delivered to customers. The holding period
depends on the nature of business. Supermarkets have short
holding periods; retail furniture stores have fairly long inven-
tory holding periods. Products should not be held in inventory
longer than necessary. Holding inventory is subject to several
risks and accrues several costs. Products may become obsolete,
may be stolen, may be damaged, or may even be misplaced.

58
I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S


Products have to be stored, usually have to be insured, and
may have to be guarded. And the capital invested in inventory
has a cost, of course.
To get a feel for how long the business holds its inventory
before sale, investors and lenders calculate the inventory
turnover ratio as follows (see Figures 4.1 and 4.2 for data):
$24,960,750 cost-of-goods sold expense
= 4.3 times
$5,760,173 inventories
The inventory turnover ratio is another of the ratios pub-
lished by business information service organizations. The
company™s 4.3 inventory turnover ratio indicates that it holds
products about one-fourth of a year before selling them. The
inventory turnover ratio is compared with the averages for the
industry and with previous years of the business.


Asset Turnover Ratio
The asset turnover ratio is a test of how well a business is
using its assets overall. This ratio is computed by dividing
annual sales revenue by total assets (see Figures 4.1 and 4.2
for data):
$39,661,250 annual sales revenue
= 1.5 times
$26,814,579 total assets
This ratio reveals that the business made $1.50 in sales for
every $1.00 of total assets. Conversely, the business needed
$1.00 of assets to make $1.50 of sales during the year. The
ratio tells us that business is relatively asset heavy. The asset
turnover ratio is compared with the averages for the industry
and with previous years of the business.



s
END POINT
Individual investors, investment managers, stock analysts,
lenders, and credit rating services commonly use the financial
statement and market value ratios explained in this chapter.
Business managers use the ratios to keep watch on how their
business is doing and whether there might be some trouble
spots that need attention. Nevertheless, the ratios are not a
panacea.
A financial statement ratio is like your body temperature. A

59
FINANCIAL REPORTING


normal temperature is good and means that probably nothing
serious is wrong, though not necessarily. A very high or low
temperature means something probably is wrong, but it takes
an additional diagnosis to discover the problem. Financial
statement ratios are like measures of vital signs such as your
pulse rate, blood pressure, cholesterol level, body fat, and so
on. Financial ratios are the vital signs of a business.
There™s no end to the number of ratios than can be calcu-
lated from financial statements. The trick is to focus on a rea-
sonable number of ratios that have the most interpretive
value. Calculating the ratios takes time. Many investors and
lenders do not actually calculate the ratios. They do “eyeball
tests” instead of computing ratios. They visually compare the
two numbers in the ratio and do rough arithmetic in their
heads to see if anything appears to be out of whack. For
example, they observe that current assets are more than twice
current liabilities. They do not bother to calculate the exact
measure of the current ratio. This is a practical and time-
saving technique as opposed to calculating ratios. Many
investors and lenders use the financial statement ratios pub-
lished by information service providers who compile data and
information on thousands of businesses.




60
2
PA R T




Assets and
Sources of
Capital
5
CHAPTER




Building a
Balance Sheet



T
This chapter identifies and explains the various assets and lia-
bilities used by a business in making profit. A business invests
in a portfolio of operating assets and takes on certain operat-
ing liabilities in the process of making sales and incurring
expenses. The main theme of the chapter is that the profit-
making activities of a business (revenue and expenses) drive
the assets and liabilities that make up its balance sheet.


SIZING UP TOTAL ASSETS
Figure 5.1 presents an abbreviated income statement for a
business™s most recent year. Previous chapters explain that
income statements include more information about expenses
and do not stop at the earnings before interest and income tax
(EBIT) line of profit. Interest and income tax expenses are
deducted to arrive at bottom-line net income. However, the
condensed and truncated income statement shown in Figure
5.1 is just fine for the purpose at hand.

This business example, like the examples in earlier chapters,
is a hypothetical but realistic composite based on a variety of
financial reports over the years. Any particular business you
look at will differ in one or more respects from the example.
Some businesses are smaller or larger than the one in the
example; their annual sales revenue may be lower or higher.
63
A S S E T S A N D S O U R C E S O F C A P I TA L




Note: Amounts are in in millions of dollars.

Sales revenue $52.0
Cost-of-goods-sold expense $31.2
Gross margin $20.8
Operating expenses $16.9
Earnings before interest and income tax (EBIT) $ 3.9
FIGURE 5.1 Abbreviated income statement.




The business in the example sells products, and therefore it
has cost-of-goods sold expense. Many businesses sell services
instead of products, and they don™t have this expense. But the
example serves as a good general-purpose template that has
broad applicability across many lines of businesses.
Y
A final comment about the example: I selected annual sales
FL
of $52 million as a convenient figure to work with (i.e., $1
million sales per week). This simplifies the computations in
the following discussion and avoids diverting attention from
AM


the main points and spending too much time on number
crunching.
TE




Two Key Questions
Block by block this chapter builds the foundation of assets the
business used to make sales of $52 million and to squeeze out
$3.9 million profit (EBIT) from its sales revenue. Let me
immediately put a question to you: What amount of total
assets would you estimate that the business used in making
annual sales of $52 million? Annual sales divided by total
assets is called the asset turnover ratio (see Chapter 4). Indi-
rectly, what I™m asking you is this: What do you think the
asset turnover ratio might be for the business?

The asset turnover ratios of businesses that manufacture and
sell products tend to cluster in the range between 1.5 and 2.0.
In other words, their annual sales revenue equals 1.5 to 2
times total assets for these kinds of businesses. To keep the
arithmetic easy to follow in the discussion, assume that the


64
BUILDING A BALANCE SHEET


total assets of the business in the example are $26 million. So
its asset turnover ratio is 2.0: ($52 million annual sales rev-
enue · $26 million total assets = 2.0). An asset turnover ratio
of 2.0 is on the high side, but I™ll stick with it in the first part
of the chapter.


The second question is this: Where did the business
get the $26 million invested in its assets? The money
for investing in assets comes from two different sources”
liabilities and owners™ equity. This point is summarized in the
well-known accounting equation:
Assets = liabilities + owners™ equity
The accounting equation is the basis for double-entry book-
keeping. The balance sheet takes its name from the balance
between assets on one side of the equation and liabilities plus
owners™ equity on the other. The balance sheet is the financial
statement that reports a business™s assets, liabilities, and own-
ers™ equity accounts.


Return on Assets
The business used $26 million total assets to earn $3.9 million
before interest and income tax, or EBIT. Dividing EBIT by total
assets gives the rate of return on assets (ROA) earned by the
business. In the example, the business earned a 15.0 percent
ROA for the year ($3.9 million EBIT · $26 million total assets =
15.0%). Is this ROA merely adequate, fairly good, or very
good? Well, relative to what benchmark or point of reference?
The business has borrowed money for part of the total $26
million total capital invested in its assets. The average annual
interest rate on its debt is 8.0 percent. Relative to this annual
interest rate the company™s 15.0 percent ROA is more than
adequate. Indeed, the favorable spread between these two
rates works to the advantage of the business owners. The
business borrows money at 8.0 percent and manages to earn
15.0 percent on the money. Chapter 6 explores the very
important issue regarding debt versus owners™ equity as
sources of capital to finance the assets of a business and dis-
cusses the advantages and risks of using debt capital.


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A S S E T S A N D S O U R C E S O F C A P I TA L



This chapter deals mainly with the types and the
amounts of assets needed to make profit. The non-
interest-bearing operating liabilities of businesses are also
included in the discussion. These short-term payables occur
spontaneously when a business buys inventory on credit,
receives money in advance for future delivery of products or
services to customers, and delays paying for expenses.
Payables arising from these sources are called spontaneous
liabilities. In contrast, borrowing money from lenders and
raising money from shareholders are anything but sponta-
neous. Persuading lenders to loan money to the business is a
protracted process, as is getting people to invest money in the
business as shareowners.


ASSETS AND SOURCES OF CAPITAL FOR ASSETS

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