Measuring Company Efficiency

By Ben McClure AAA

Analyzing a company's inventories and receivables is a reliable means of helping to determine whether it is a good investment play or not. Companies stay efficient and competitive by keeping inventory levels down and speeding up collection of what they are owed. In this article, we'll take you through the process step by step.

SEE: The Working Capital Position

Getting Goods off the Shelf
As an investor, you want to know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventory - they can't stock a lifetime supply of every item. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers. Inventory turnover measures how quickly the company is moving merchandise through the warehouse to customers.

Let's look at U.S. retail giant Walmart, known for its super-efficient operations and state-of-the-art supply chain system, which keeps inventories at a bare minimum. In fiscal 2011, inventory sat on its shelves for an average of 40 days. Like most companies, Walmart doesn't provide inventory turnover numbers to investors, but they can be flushed out using data from Walmart's financial statements.

Inventory Days = 365 Days / (Average Cost of Goods Sold/Average Inventory)

Obtaining Average COGS
To get the necessary data, find its Consolidated Statements of Income on the company's website and locate cost of goods sold (COGS), or "cost of sales" found just below the top-line sales (revenue). For the 2011 fiscal year, Walmart's COGS totaled US$315.29 billion.

Obtaining Average Inventory
Then look at the Consolidated Balance Sheet (the next page after Statements of Income). Under assets, you will find the inventory figure. For 2011, Walmart's inventory was $36.3 billion, and in 2010, it was $32.7 billion. Average the two numbers ($36.3 billion + $32.7 billion / 2 = $34.5 billion), then divide that inventory average, $34.5 billion, into the average cost of goods sold in 2011. You will arrive at the annual turnover ratio 9.1. Now, divide the number of days in the year, 365, by the annual turnover ratio, 9.1, and that gives you 40.1. That means it takes Walmart about 40 days, or about a month and a half, to cycle through its inventory. This number of inventory days is also known as the "days-to-sell" figure.

Broadly speaking, the smaller number of days, the more efficient a company - inventory is held for less time and less money is tied up in inventory. Using the same calculations above, Walmart's numbers back in 2003 yielded 45 days, which goes to show that within that decade range, the company has increased its inventory efficiency. Thus, money is freed up for things like research and development, marketing or even share buybacks and dividend payments. If the number of days is high, that could mean that sales are poor and inventories are piling up in warehouses.

SEE: How To Evaluate A Company's Balance Sheet

Remember, however, that it's not enough to know the number at any specific time. Investors need to know if the days-to-sell inventory figure is getting better or worse over several periods. To get a decent sense of the trend, calculate at least two years' worth of quarterly inventory sales numbers.

If you do spot an obvious trend in the numbers, it's worthwhile asking why. Investors would be pleased if the number of inventory days were falling because of greater efficiencies gained through tighter inventory controls. On the other hand, products may be moving off the shelf more quickly simply because the company is cutting its prices.

To get an answer, flip to the Income Statement and look at Walmart's gross margin (top-line revenue, or net sales, minus cost of sales). Check to see whether gross margins as a percentage of revenue/net sales are on an upward or downward trajectory. Gross margins, which are consistent or on-the-rise offer an encouraging sign of improved efficiencies. Shrinking margins, on the other hand, suggest the company is resorting to price cuts to boost sales. Looking back at the numbers, you will find that Walmart's gross margins, as expressed as a percentage of net sales, went down 0.2% from 24.9% in 2010 to 24.7% in 2011 (gross margin = net sales - COGS/net sales).

If inventory days are increasing, that's not necessarily a bad thing. Companies normally let inventories build up when they are introducing a new product in the market or ahead of a busy sales period. However, if you don't foresee an obvious pick-up in demand coming, the increase could mean that unsold goods will simply collect dust in the stockroom.

Collecting What's Owed - Soon!

Accounts receivable is the money that is currently owed to a company by its customers. Analyzing the speed at which a company collects what it is owed can tell you a lot about its financial efficiency. If a company's collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can spell trouble later on, especially if customers face a cash crunch. Getting money right away is preferable to waiting for it - especially since some of what is owed may never be paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise and equipment, loans and, best of all, dividends and growth opportunities.

Therefore, investors should determine how many days, on average, the company takes to collect its accounts receivable. Here is the formula:

Receivables Days = 365 Days / (Revenues/Average Receivables)

On the top of the Income Statement, you will find revenues. On the Balance Sheet under current assets, you will find accounts receivable. Walmart generated $418.9 billion in net sales in 2011. At the end of that year, its accounts receivable stood at $5 billion, and in 2010, it was $4 billion, yielding an average accounts receivable figure of about $7 billion.

Dividing revenue by average receivables gives a receivables turnover ratio of 60. This shows how many times the company turned over its receivables in the annual period. Three hundred and sixty-five days of the year divided by the receivables turnover ratio of 60 gives a receivables turnover rate of three days. On average, it took about a week for Walmart to receive payment for the goods it sold.

SEE: Read This Before You Sell

Sizing-up Efficiencies
It's good news when you see a shortening of both inventory days and the collection period. Still, that's not enough to fully understand how a company is running. To gauge real efficiency, you need to see how the company stacks up against other players in the industry.

Let's see how Walmart compared in 2003 to Target Stores, another large, publicly-listed retail chain. Dramatic differences can be seen. While Walmart, on average, turned over its inventory every 40 days during that period, Target's inventory turnover took nearly 61 days. Walmart collected payments in just three days. Meanwhile, Target, which relied heavily on slow-to-collect credit card revenues, required almost 64 days to get its money. As Walmart shows, using competitors as a benchmark can enhance investors' sense of a company's real efficiency.

SEE: A Look At Corporate Profit Margins

Still, comparative numbers can be deceiving if investors don't do enough research. Just because one firm's numbers are lower than a rival's, doesn't mean that one firm will have a more efficient performance. Business models and product mix need to be taken into account. Inventory cycles differ from industry to industry.

Keep in mind that these efficiency measures apply largely to companies that make or sell goods. Software companies and firms that sell intellectual property as well as many service companies do not carry inventory as part of their day-to-day business, so the inventory days' metric is of little value when analyzing these kinds of companies. However, you can certainly use the days' receivables formula to examine how efficiently these companies collect what's owed.

The Bottom Line
Finding out where a firm's cash is tied up in inventories and receivables can help shed light on its how efficiently it is being managed. Of course, it takes time and effort to extract the information from company financial statements. However, doing the analysis will certainly help you find which companies are worthy of investment.

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