PERIOD ENDING
We explore each element in more detail in the following sections. From here on, refer to Figure 7-1, the condensed version of Simpson’s balance sheet obtained from Yahoo! Finance. It is typical of what is shown in most financial portals, and is based on the same set of numbers shown from the Simpson annual report in Figure 6-1.
Cash and cash equivalents
For most businesses, cash is the best asset it can have. There’s no question about its value — cash is cash — and it’s the most useful and flexible asset a business can have. Cash equivalents, which are short-term marketable secu- rities with little to no price risk, can be converted to cash at a moment’s notice and are, for balance sheet purposes, essentially cash.
Value investors like cash. Cash is security and forms the strongest part of the
“safety net” that value investors seek. Value investors question a cash bal- ance only if it appears excessive against the needs of the business. If Simpson had a billion dollars in cash — more than one year of sales — you may ask why. Could the company not put that cash to work in an investment or acqui- sition that may return more than the 4 or 5 percent it may get in a bank? And why isn’t it being returned to shareholders? Most companies don’t retain that much cash, but occasionally it becomes a value investing red flag.
It’s important to recognize the total picture when companies report high cash balances. Many companies have large cash or cash equivalent balances for a while immediately following an initial public offering (IPO). For example, at the end of the year 1999, Webvan Group had $500 million, well over one year’s sales. Why? Because they just went public. They just received a huge contribution of owners’ equity in the form of cash. That’s what an IPO is all about. That cash is there to be depleted (hence the term “burn rate”), hope- fully to produce a favorable return. But that scenario, as you know, comes with a lot of risk. Cash is hardly a safety net in this kind of company; you need to look at cash differently.
Cash on the balance sheet is great to have, and for most businesses beyond the IPO situation a cash balance reflects profits received at some point in the course of business. But for some companies — like banks and other financial services companies — cash is more like inventory. Banks take in cash and lend it out to generate profits. A cash snapshot at a given point in time is less about profits and more about inventory levels carried, and thus isn’t as clear an indicator of business success or flexibility.
Accounts receivable
Accounts receivablerepresent funds that are owed to the business, presum- ably for products delivered or services performed. As individuals, everyone likes to be owed money — until we’re owed too muchmoney. The same prin- ciple applies to businesses.
Accounts receivable are driven by the type of business that a company oper- ates in. Obviously a small-sale retailer such as Starbucks operates mostly on cash — you don’t give them an IOU for that double-cream latte, do you? Even when you charge something, the credit card company pays almostimmedi- ately, leaving perhaps a slight residual in accounts receivable. Most compa- nies that sell directly to consumers have little to no accounts receivable.
Contrast this to companies that sell to other companies (business-to-business, or “b-to-b”), or to distributors or retailers in the supply food chain. Most of this business is done on account,meaning that goods or services are deliv- ered and invoices are then cut and sent. The billing process creates an account receivable, which goes away only when the customer pays the bill.
So suppliers to other businesses or through distribution and sales channels often have significant accounts receivable.
How much of a company’s asset base should be made up of accounts receiv- able? U.S. government data suggest that cash businesses such as Starbucks or grocery stores have 10 percent or less of their asset base in accounts receivable. Traditional retailers and other “b-to-c” (business-to-consumer) companies have 20 percent to 30 percent or more in receivables if they pro- vide credit through their own credit card. Equipment manufacturers and other b-to-b concerns sometimes carry receivables of 50 percent or more of total assets.
For most “b-to-b” industries, accounts receivable are a part of doing business and, in a sense, a costof doing business (cash is forgone to give the customer time to pay). The question is how much commitment to accounts receivable is necessary to support the business? You should be aware of situations in which companies aren’t collecting on their bills or are using accounts receiv- able to create credit incentives for otherwise questionable customers to buy their product.
To assign value to accounts receivable, pay attention to the following:
The size of accounts receivable relative to sales and other assets:Is a company extending itself too much to sustain or grow the business?
Ratios (covered in Chapter 10) help measure this, and industry compar- isons and common sense dictate the answer.
Trend:Is the company continuously owed more and more, with poten- tially greater and greater exposure to nonpayment? Look at historical accounts receivable and compare them to sales.
Quality of accounts receivable:Typically, most companies collect on more than 95 percent of their accounts receivable balances, and thus they’re almost as good as cash. But if accounts receivable balances grow and particularly if large reserves show up on the income statement (“allowance for doubtful accounts” or similar), this is a red flare not to be missed. Unfortunately, most investors don’t see information on indi- vidual creditors nor can they assess their credit-worthiness.
Some financial statements show “notes receivable” as a separate balance sheet item under current assets. Notes receivable are essentially a special form of accounts receivable — a promissory note for a significant sum extended to a specific firm for a specific reason. For the most part, these should be treated like normal accounts receivable, but it may be worth a quick glance at the note holder and the terms of the note. For example, a note granted by Boeing to a weak or bankrupt airline may be cause for concern.
Inventory
Inventory can be a critical, make-or-break asset and factor in company valua- tion. Companies live and die by their ability to effectively manage inventory.
Inventoryis all valued material procured by a business and resold, with or without value add, to a customer. Retail inventoryconsists of goods bought, warehoused, and sold through stores. Manufacturing inventoryconsists of raw material, work in process, and finished goods inventory awaiting shipment.
For most companies, the key to successfully managing inventory is to match it as closely as possible to sales. That is, the faster that procured inventory can be processed and sold, the better. More sales are generated per dollar tied up in inventory. Dollars tied up in inventory cost money because they could be invested elsewhere in the business.
Measuring inventory
Measuring the size of inventory assets is often done by measuring turnover.
Turnoveris simply annual sales divided by the dollar amount of the asset on the books. If sales are $500 million a year and inventory on the books is $100 million, inventory turnover is 5 times a year. Another way to look at it: The average item of inventory is on the books for about 2.4 months (12 ÷ 5). Some would represent that figure as “months’ sales in inventory,” or “months of supply.” The greater the turnover, the more efficient the utilization of that asset. Turnover ratios naturally vary by industry. For example, Starbucks turns over inventory much faster than Boeing.
Moreover, inventory carries with it a significant risk of obsolescence. Changes in demand patterns, technology, or the nature of the product itself can cause valued inventory to rapidly lose value. The most extreme example of obsoles- cence risk is newspapers, where an inventory of today’s latest edition becomes almost 100 percent worthless at the stroke of midnight. But almost any other type of inventory carries obsolescence risk, as few inventories are worth 100 percent of their purchase price or anywhere near it.
Incidentally, accounts receivable are another asset that can, and often are, measured by turnover. You may choose to measure it as “days’ sales in receivables.” A company with a normal 30-day billing cycle that has 45 days’
sales in receivables has a problem.
Valuing inventory
Valuing an inventory asset can be challenging. Companies don’t provide much information about their inventories. About as far as you’ll normally get is a breakdown of how much inventory is in “finished goods” and “purchased parts and fabricated assemblies,” and even that is buried deep in the 10-K (the 10-K is discussed in Chapter 6). The value investor knows little about what those inventories really are or about their real value. A warehouse of outdated Pentium III computer processors probably carries a book inventory value, but they aren’t worth much to the company or anyone else.
Inventory valuation is further affected by accounting methods employed by a firm. The method affects both balance sheet carrying value and cost recogni- tion on the income statement. Mainly the choices are “first in, first out”
(FIFO) and “last in, first out” (LIFO), meaning that a company assigns either the earliest stocked goods or the latest stocked goods to a sale. In a normal environment in which costs increase over time, LIFO will result in a more con- servative view of earnings and inventory balances — the more expensive items are assumed to be consumed first. (This approach may not work in technology companies, where more recently purchased components are actu- ally cheaper — LIFO may be less conservative!)
The FIFO versus LIFO decision is documented in annual report notes, usually Note 1, significant accounting policies. Under normal circumstances, you probably don’t need to be tooconcerned about this, unless industry price instability or inflation becomes a big factor. Also watch for accounting policy changes, which can be used to hide or inflate performance.
Further refining the reported value of inventory is the decision to carry at the lower of cost or market. Costis as implied — what the material cost in the first place. LIFO or FIFO affects the cost carried. But the most conservative inven- tory valuation practice is to carry at market,which is what the company thinks the market value of its inventory is on the resale market. Normally this comes closer to a true valuation for the inventory, but it depends on the company’s assessment and the recency of that assessment. Most companies carry at the lower of cost or market, but again, look for valuation practice in the notes section.
Investors should keep an eye on inventory balances for economic value and efficiency of use. Look at the size of the asset in an absolute sense and rela- tive to the size and sales of the business. Look for trends, favorable and unfa- vorable, in inventory balances and ratios. Look at competitors and industry standards. Where possible, look at inventory quality and past track record for inventory obsolescence and resulting write-offs. And then be conserva- tive. It often makes sense to assign a value of 50 percent to 75 percent, some- times less, to inventory values appearing on a balance sheet.
As in most other aspects of value investing, it is important to know something about the industry when assigning value to balance sheet assets. Suppose you’re an investor in bookseller Borders Group. You may be alarmed by the
$1.4 billion in merchandise inventories carried on the Borders Group balance sheet, a figure that’s more than half of the total assets with fewer than three turns per year ($4.1 billion in sales). But a closer look at the book industry reveals a special case: Booksellers are entitled to return nearly all inventory to publishers for 100 percent credit! Booksellers need to stock even the slow movers to get people into the stores, so publishers realize this and have created this policy to get their inventory onto the shelves. So although the Borders book inventory is large and requires significant cash tie-up, it carries with it far less risk of obsolescence and future write-offs than many of its retailing brethren. Know thy business and know thy industry.
Deferred taxes and other current assets
Most balance sheets contain small amounts for other items carried on the books. “Deferred taxes” is an item that appears frequently and results from timing differences between financial reporting and tax reporting requirements.