Chapter4: Analyzing Financial Statements
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Chapter4: Analyzing Financial Statements
4.1 BACKGROUND FOR FINANCIAL STATEMENT ANALYSIS
This chapter will guide you through a typical financial statement analysis, which involves the use of financial statements to analyze a company’s performance and assess its strengths and weaknesses. First, we look at the different perspectives we can take when analyzing financial statements; then we present some helpful guidelines for financial statement analysis.
Perspectives on Financial Statement Analysis
Stockholders and stakeholders may differ in the information they want to gain when analyzing financial statements. In this section, we discuss three perspectives from which we can view financial statement analysis: those of (1) stockholders, (2) managers, and (3) creditors.
Stockholders’ Perspective
Stockholders are primarily concerned with the value of their stock and with how much cash they can expect to receive from dividends and capital appreciation over time. Therefore, stockholders want financial statements to tell them how profitable the firm is, what the return on their investment is, and how much cash is available for stockholders, both in total and on a per-share basis. Ultimately, stockholders are interested in how much a share of stock is worth. We address pricing issues in detail in Chapter 9, but financial analysis is a key step in valuing a company’s stock.
Managers’ Perspective
Broadly speaking, management’s perspective of financial statement analysis is similar to that of stockholders. The reason is that stockholders own the firm and managers have a fiduciary responsibility to make decisions that are in the owners’ best interests. Thus, managers are interested in the same performance measures as stockholders: profitability, how much cash is available for stockholders, capital appreciation, return on investment, and the like.
Managers, however, are also responsible for running the business on a daily basis and must make decisions that will maximize the value of the stockholders’ shares in the long run. Maximizing the value of the stockholders’ shares does not involve a single big decision, but rather a series of smaller day-to-day decisions. Thus, managers need feedback on the short-term impact these day-to-day decisions have on the firm’s financial statements and its current stock price. For example, managers can track trends in sales and can determine how well they are controlling expenses and how much of each sales dollar goes to the bottom line. In addition, managers can see the impact of their capital budgeting, financing, and working capital decisions reflected in the financial statements. Keep in mind that managers, as insiders, have access to much more detailed financial information than those outside the firm. Generally, outsiders only have access to published financial statements for publicly traded firms.
Creditors’ Perspective
The primary concern of creditors is whether and when they will receive the interest payments they are entitled to and when they will be repaid the money they loaned to the firm. Thus, a firm’s creditors, including long-term bondholders, closely monitor how much debt the firm is currently using, whether the firm is generating enough cash to pay its day-to-day bills, and whether the firm will have sufficient cash in the future to make interest and principal payments on long-term debt after satisfying obligations that have a higher legal priority, such as paying employees’ wages. Of course, the firm’s ability to pay interest and principal ultimately depends on cash flows and profitability; hence, creditors—like stockholders and managers—are interested in those aspects of the firm’s financial performance.
Guidelines for Financial Statement Analysis
We turn now to some general guidelines that will help you when analyzing a firm’s financial statements. First, make sure you understand which perspective you are adopting to conduct your analysis: stockholder, manager, or creditor. The perspective will dictate the type of information you need for the analysis and may affect the actions you take based on the results.
Second, always use audited financial statements if they are available. As we discussed in Chapter 1, an audit means that an independent accountant has attested that the financial statements present fairly, in all material respects, the firm’s financial condition at a point in time. If the statements are unaudited, your analysis will require extra effort. For example, if you are a creditor considering making a loan, you will need to undertake an especially diligent examination of the company’s books before closing the deal. It would also be a good idea to make sure you know the company’s management team and accountant very well. This will provide additional insight into the creditworthiness of the firm.
Third, use financial statements that cover three to five years, or more, to conduct your analysis. This enables you to perform a trend analysis, which involves looking at historical financial statements to see how various ratios are increasing, decreasing, or staying constant over time.
Fourth, when possible, it is always best to compare a firm’s financial statements with those of competitors that are roughly the same size and that offer similar products and services. If you compare firms of disparate size, the results may be meaningless because the two firms may have very different infrastructures, sources of financing, production capabilities, product mixes, and distribution channels. For example, comparing The Boeing Company’s financial statements with those of Piper Aircraft, a firm that manufactures small aircraft, makes no sense whatsoever, although both firms manufacture aircraft. You will have to use your judgment as to whether relevant comparisons can be made between firms with large size differences.
In business it is common to benchmark a firm’s performance, as discussed in the previous paragraph. The most common type of benchmarking involves comparing a firm’s performance with the performance of similar firms that are relevant competitors. For example, Ford Motor Company management may want to benchmark the firm against General Motors and Toyota, Ford’s major competitors in the world market. Firms can also be benchmarked against themselves. For example, they can compare this year’s performance with last year’s performance or with a specific goal, such as a 10 percent growth in sales. We discuss benchmarking in more detail later in this chapter.
4.2 COMMON-SIZE FINANCIAL STATEMENTS
A common-size financial statement is one in which each number is expressed as a percentage of some base number, such as total assets or net revenues (net sales). For example, each number on a balance sheet may be divided by total assets. Dividing numbers by a common base to form a ratio is called scaling. Scaling is an important concept, and you will read more about it later in this chapter, in the discussion of financial ratios. Financial statements scaled in this manner are also called standardized financial statements.
Common-size financial statements make it easier to evaluate changes in a firm’s performance and financial condition over time. They also allow you to make more meaningful comparisons between the financial statements of two firms that are different in size. For example, in the oil and gas field equipment market, Schlumberger Limited is the major competitor of Diaz Manufacturing, the illustrative firm introduced in Chapter 3. However, Schlumberger has over $55 billion in total assets while Diaz Manufacturing’s assets total only $1.9 billion. Without common-size financial statements, comparisons of these two firms would be difficult to interpret. Common-size financial statements are also useful for analyzing trends within a single firm over time, as you will see.
Common-Size Balance Sheets
To create a common-size balance sheet, we divide each of the asset accounts by total assets. We also divide each of the liability and equity accounts by total assets since .
You can see the common-size balance sheet for Diaz Manufacturing in Exhibit 4.1. Assets are shown in the top portion of the exhibit, and liabilities and equity in the lower portion. The calculations are simple. For example, on the asset side in 2014, cash and marketable securities were 15.3 percent of total assets ( , or 15.3 percent) and inventory was 22.4 percent of total assets ( , or 22.4 percent). Notice that the percentages of total assets add up to 100 percent. On the liability side, accounts payable are 18.5 percent of total assets ( , or 18.5 percent), and long-term debt is 30.4 percent ( , or 30.4 percent). To test yourself, see if you can re-create the percentages in Exhibit 4.1 using your calculator. Make sure the percentages add up to 100, but realize that you may obtain slight variations from 100 because of rounding.
2014 2013 2012
% of Assets % of Assets % of Assets
Assets:
Cash and marketable securities $ 288.5 15.3 $ 16.6 1.1 $ 8.2 0.6
Accounts receivable 306.2 16.2 268.8 18.0 271.5 19.4
Inventories 423.8 22.4 372.7 24.9 400.0 28.6
Other current assets 21.3 1.1 29.9 2.0 24.8 1.8
Total current assets $1,039.8 55.0 $ 688.0 46.1 $ 704.5 50.4
Plant and equipment (net) 399.4 21.1 394.2 26.4 419.6 30.0
Goodwill and other assets 450.0 23.8 411.6 27.6 273.9 19.6
Total assets $1,889.2 100.0 $1,493.8 100.0 $1,398.0 100.0
Liabilities and Stockholders’ Equity:
Accounts payable and accruals $ 349.3 18.5 $ 325.0 21.8 $ 395.0 28.3
Notes payable 10.5 0.6 4.2 0.3 14.5 1.0
Accrued income taxes 18.0 1.0 16.8 1.1 12.4 0.9
Total current liabilities $ 377.8 20.0 $ 346.0 23.2 $ 421.9 30.2
Long-term debt 574.0 30.4 305.6 20.5 295.6 21.1
Total liabilities $ 951.8 50.4 $ 651.6 43.6 $ 717.5 51.3
Common stock (54,566,054 shares) 0.5 0.0 0.5 0.0 0.5 0.0
Additional paid in capital 892.4 47.2 892.4 59.7 892.4 63.8
Retained earnings 67.8 3.6 (50.7) (3.4) (155.8) (11.1)
Less: Treasury stock (23.3) (1.2) — — (56.6) (4.0)
Total stockholders’ equity $ 937.4 49.6 $ 842.2 56.4 $ 680.5 48.7
Total liabilities and equity $1,889.2 100.0 $1,493.8 100.0 $1,398.0 100.0
EXHIBIT 4.1 Common-Size Balance Sheets for Diaz Manufacturing on December 31 ($ millions)In common-size balance sheets, such as those in this exhibit, each asset account and each liability and equity account is expressed as a percentage of total assets. Common-size statements allow financial analysts to compare firms that are different in size and to identify trends within a single firm over time.
What kind of information can Exhibit 4.1 tell us about Diaz Manufacturing’s operations? Here are some examples. Notice that in 2014, inventories accounted for 22.4 percent of total assets, down from 24.9 percent in 2013 and 28.6 percent in 2012. In other words, Diaz Manufacturing has been steadily reducing the proportion of its money tied up in inventory. This is probably good news because it is usually a sign of more efficient inventory management.
Now look at liabilities and equity, and notice that in 2014 total liabilities represent 50.4 percent of Diaz Manufacturing’s total liabilities and equity. This means that common stockholders have provided 49.6 percent of the firm’s total financing and that creditors have provided 50.4 percent of the financing. In addition, you can see that from 2012 to 2014, Diaz Manufacturing substantially increased the proportion of financing from long-term debt holders. Long-term debt provided 21.1 percent ( , or 21.1 percent) of the financing in 2012 and 30.4 percent ( , or 30.4 percent) in 2014.
Overall, we can identify the following trends in Diaz Manufacturing’s common-size balance sheet. First, Diaz Manufacturing is a growing company. Its assets increased from $1,398.0 million in 2012 to $1,889.2 million in 2014. Second, the percentage of total assets held in current assets grew from 2012 to 2014, a sign of increasing liquidity. Recall from Chapter 2 that assets are liquid if they can be sold easily and quickly for cash without a loss of value. Third, the percentage of total assets in plant and equipment declined from 2012 to 2014, a sign that Diaz Manufacturing is becoming more efficient because it is using fewer long-term assets in producing sales (below you will see that net sales have increased over the same period). Finally, as mentioned, Diaz Manufacturing has significantly increased the percentage of its financing from long-term debt. Generally, these are considered signs of a solidly performing company, but we have a long way to go before we can confidently reach that conclusion. We will now turn to Diaz Manufacturing’s common-size income statement.
Common-Size Income Statements
The most useful way to prepare a common-size income statement is to express each account as a percentage of net sales, as shown for Diaz Manufacturing in Exhibit 4.2. Net sales are defined as total sales less all sales discounts and sales returns and allowances. You should note that when looking at accounting information and sales numbers as reported, they almost always mean net sales, unless otherwise stated. We will follow this convention in the book. Again, the percent calculations are simple. For example, in 2014 selling and administrative expenses are , and net income is . Before proceeding, make sure that you can verify each percentage in Exhibit 4.2 with your calculator.
2014 2013 2012
% of Net Sales % of Net Sales % of Net Sales
Net sales $1,563.7 100.0 $1,386.7 100.0 $1,475.1 100.0
Cost of goods sold 1,081.1 69.1 974.8 70.3 1,076.3 73.0
Selling and administrative expenses 231.1 14.8 197.4 14.2 205.7 13.9
Earnings before interest, taxes, depreciation, and amortization (EBITDA) $ 251.5 16.1 $ 214.5 15.5 $ 193.1 13.1
Depreciation 83.1 5.3 75.3 5.4 71.2 4.8
Earnings before interest and taxes (EBIT) $ 168.4 10.8 $ 139.2 10.0 $ 121.9 8.3
Interest expense 5.6 0.4 18.0 1.3 27.8 1.9
Earnings before taxes (EBT) $ 162.8 10.4 $ 121.2 8.7 $ 94.1 6.4
Taxes 44.3 2.8 16.1 1.2 27.9 1.9
Net income $ 118.5 7.6 $ 105.1 7.6 $ 66.2 4.5
Dividends — — —
Addition to retained earnings $ 118.5 $ 105.1 $ 66.2
EXHIBIT 4.2 Common-Size Income Statements for Diaz Manufacturing for Fiscal Years Ending December 31 ($ millions)Common-size income statements express each account as a percentage of net sales. These statements allow financial analysts to better compare firms of different sizes and to analyze trends in a single firm’s income statement accounts over time.
Interpreting the common-size income statement is also straightforward. As you move down the income statement, you will find out exactly what happens to each dollar of sales that the firm generates. For example, in 2014 it cost Diaz Manufacturing 69.1 cents in cost of goods sold to generate one dollar of sales. Similarly, it cost 14.8 cents in selling and administrative expenses to generate a dollar of sales. The government takes 2.8 percent of sales in the form of taxes.
The common-size income statement can tell us a lot about a firm’s efficiency and profitability. For example
, in 2012, Diaz Manufacturing’s cost of goods sold and selling and administrative expenses totaled . By 2014, these expenses declined to . This might mean that Diaz Manufacturing is negotiating lower prices from its suppliers or is more efficient in its use of materials and labor. It could also mean that the company is getting higher prices for its products, perhaps by offering fewer discounts or rebates. The important point, however, is that more of each dollar of sales is contributing to net income.
The trends in the income statement and balance sheet suggest that Diaz Manufacturing is improving along a number of dimensions. The real question, however, is whether Diaz Manufacturing is performing as well as other firms in the same industry. For example, the fact that 7.6 cents of every dollar of sales reaches the bottom line may not be a good sign if we find out that Diaz Manufacturing’s competitors average 10 cents of net income for every dollar of sales.
4.3 FINANCIAL RATIOS AND FIRM PERFORMANCE
In addition to the common-size ratios we have just discussed, other specialized financial ratios help analysts interpret the myriad of numbers in financial statements. In this section we examine financial ratios that measure a firm’s liquidity, efficiency, leverage, profitability, and market value, using Diaz Manufacturing as an example. Keep in mind that for ratio analysis to be most useful, it should also include trend and benchmark analyses, which we discuss in more detail later in this chapter.
Why Ratios Are Better Measures
A financial ratio is simply one number from a financial statement that has been divided by another financial number. Like the percentages in common-size financial statements, ratios eliminate problems arising from differences in size because the denominator of the ratio adjusts, or scales, the numerator to a common base.
Here’s an example. Suppose you want to assess the profitability of two firms. Firm A’s net income is $5, and firm B’s is $50. Which firm had the best performance? You really cannot tell because you have no idea what asset base was used to generate the income. In this case, a relevant measure of financial performance for a stockholder might be net income scaled by the firm’s stockholders’ equity—that is, the return on equity (ROE):
If firm A’s total stockholders’ equity is $25 and firm B’s stockholders’ equity is $5,000, the ROE for each firm is as follows:
Firm ROE Calculation ROE
A $5/$25 0.20, or 20%
B $50/$5,000 0.01, or 1%
As you can see, the ROE for firm A is 20 percent—much larger than the ROE for firm B at 1 percent. Even though firm B had the higher net income in absolute terms ($50 versus $5), its stockholders had invested more money in the firm ($5,000 versus $25), and it generated less income per dollar of invested equity than firm A. Clearly, firm A’s performance is better than firm B’s, given its smaller equity investment. The bottom line is that accounting numbers are more easily compared and interpreted when they are scaled.
Choice of Scale Is Important
An important decision is your choice of the “size factor” for scaling. The size factor you select must be relevant and make economic sense. For example, suppose you want a measure that will enable you to compare the productivity of employees at a particular plant with the productivity of employees at other plants that make similar products. Your assistant makes a suggestion: divide net income by the number of parking spaces available at the plant. Will this ratio tell you how productive labor is at a plant? Clearly, the answer is no.
Your assistant comes up with another idea: divide net income by the number of employees. This ratio makes sense as a measure of employee productivity. A higher ratio indicates that employees are more productive because, on average, each employee is generating more income. In business, the type of variable most commonly used for scaling is a measure of size, such as total assets or total net sales. Other scaling variables are used in specific industries where they are especially informative. For example, in the airline industry, a key measure of performance is revenue per available seat mile; in the steel industry, it is sales or cost per ton; and in the automobile industry, it is cost per car.
Other Comments on Ratios
The ratios we present in this chapter are widely accepted and are almost always included in any financial workup. However, you will find that different analysts will compute many of these standard ratios slightly differently. Modest variation in how ratios are computed are not a problem as long as the analyst carefully documents the work done and discloses the ratio formula. These differences are particularly important when you are comparing data from different sources.
Short-Term Liquidity Ratios
Liquid assets have active secondary markets and can be sold quickly for cash without a loss of value. Some assets are more liquid than others. For example, short-term marketable securities are very liquid because they can be easily sold in the secondary market at or near the original purchase price. In contrast, plant and equipment can take months or years to sell and often must be sold substantially below the cost of building or acquiring them.
When we examine a company’s liquidity position, we want to know whether the firm can pay its bills when cash flow from operations is insufficient to pay short-term obligations, such as payroll, invoices from vendors, and maturing bank loans. As the name implies, short-term liquidity ratios focus on whether the firm has the ability to convert current assets into cash quickly without loss of value. As we have noted before, even a profitable business can fail if it cannot pay its current bills on time. The inability to pay debts when they are due is known as insolvency. Thus, liquidity ratios are also known as short-term solvency ratios. The two most important liquidity ratios are the current ratio and the quick ratio.
The Current Ratio
To calculate the current ratio, we divide current assets by current liabilities.The formula is presented below, along with a calculation of the current ratio for Diaz Manufacturing for 2014 based on balance sheet account data from Exhibit 4.1:
(4.1)
Diaz Manufacturing’s current ratio is 2.75, which should be read as “2.75 times.” What does this number mean? If Diaz Manufacturing were to take its current supply of cash and add to it the proceeds of liquidating its other current assets—such as marketable securities, accounts receivable, and inventory—it would have $1,039.8 million. This $1,039.8 million would cover the firm’s short-term obligations of $377.8 million approximately 2.75 times, leaving a cushion of .
Now turn to Exhibit 4.3, which shows the ratios discussed in this chapter for Diaz Manufacturing for the three-year period 2012-2014. The exhibit will allow us to identify important trends in the company’s financial statements. Note that Diaz Manufacturing’s current ratio has been steadily increasing over time. What does this trend mean? From the perspective of a potential creditor, it is a positive sign. To a potential creditor, more liquidity is better because it means that the firm has a greater ability, at least in the short term, to make payments. From a stockholder’s perspective, however, too much liquidity is not necessarily a good thing. If we were to discover that Diaz Manufacturing has a much higher current ratio than its competitors, it could mean that management is being too conservative by keeping too much money tied up in current assets, leaving less cash flow for investors. Generally, more liquidity is better and is a sign of a healthy firm. Only a benchmark analysis can tell us the complete story, however.
Financial Ratio 2014 2013 2012
Liquidity Ratios:
Current ratio 2.75 1.99 1.67
Quick ratio 1.63 0.91 0.72
Efficiency Ratios:
Inventory turnover 2.55 2.62 2.69
Day’s sales in inventory 143.14 139.31 135.69
Accounts receivable turnover 5.11 5.16 5.43
Day’s sales outstanding 71.43 70.74 67.22
Total asset turnover 0.83 0.93 1.06
Fixed asset turnover 3.92 3.52 3.52
Leverage Ratios:
Total debt ratio 0.50 0.44 0.51
Debt-to-equity ratio 1.02 0.77 1.05
Equity multiplier 2.02 1.77 2.05
Times interest earned 30.07 7.73 4.38
Cash coverage 44.91 11.92 6.95
Profitability Ratios:
Gross profit margin 30.86% 29.70% 27.04%
Operating profit margin 10.77% 10.04% 8.26%
Net profit margin 7.58% 7.58% 4.49%
EBIT return on assets 8.91% 9.32% 8.72%
Return on assets 6.27% 7.04% 4.74%
Return on equity 12.64% 12.48% 9.73%
Market-Value Indicators:
Price-earnings ratio 22.40 18.43 14.29
Earnings per share $ 2.17 $ 1.93 $ 1.21
Market-to-book ratio 2.83 1.63 1.39
Note: Numbers may not add up because of rounding.
EXHIBIT 4.3 Ratios for Time-Trend Analysis for Diaz Manufacturing for Fiscal Years Ending December 31Comparing how financial ratios, such as these ratios for Diaz Manufacturing, change over time enables financial analysts to identify trends in company performance.
The Quick Ratio
The quick ratio is similar to the current ratio except that inventory is subtracted from current assets in the numerator. The quick ratio accounts for the fact that inventory is often much less liquid than other current assets. Inventory is the most difficult current asset to convert to cash without loss of value. Of course, the liquidity of inventory varies with the industry. For example, inventory of a raw material commodity, such as gold or crude oil, is more likely to be sold with little loss in value than inventory consisting of perishables, such as fruit, or fashion items, such as basketball shoes. Another reason for excluding inventory in the quick ratio calculation is that the book value of inventory may be significantly more than its market value because it may be obsolete, partially completed, spoiled, out of fashion, or out of season.
To calculate the quick ratio—or acid-test ratio, as it is sometimes called—we divide current assets, less inventory, by current liabilities. The calculation for Diaz Manufacturing for 2014 is as follows, based on balance sheet data from Exhibit 4.1:
(4.2)
The quick ratio of 1.63 times means that if we exclude inventory, Diaz Manufacturing had $1.63 of current assets for each dollar of current liabilities. You can see from Exhibit 4.3 that Diaz Manufacturing’s liquidity position, as measured by its quick ratio, has been increasing over time.
Note that the quick ratio is usually less than the current ratio, as it was for Diaz Manufacturing in 2014.The quick ratio is a very conservative measure of liquidity because the calculation assumes that the inventory is valued at zero, which in most cases is not a realistic assumption. Even in a bankruptcy “fire sale,” the inventory can be sold for some small percentage of its book value, generating at least some cash.
Efficiency Ratios
We now turn to a group of ratios called efficiency ratios or asset turnover ratios, which measure how efficiently a firm uses it assets. These ratios are quite useful for managers and financial analysts in identifying the inefficient use of current and long-term assets. They are also valuable for a firm’s investors who use the ratios to find out how quickly a firm is selling its inventory and converting receivables into cash flow for investors.
Inventory Turnover and Days’ Sales in Inventory
We measure inventory turnover by dividing the cost of goods sold from the income statement by inventory from the balance sheet (see Exhibits 4.1 and 4.2). The cost of goods sold is used because it reflects the book value of the inventory that is sold by a firm. The formula for inventory turnover and its value for Diaz Manufacturing in 2014 are:
(4.3)
The firm “turned over” its inventory 2.55 times during the year. Looking back at Exhibit 4.3, you can see that this ratio remained about the same over the period covered.
What exactly does “turning over” inventory mean? Consider a simple example. Assume that a firm starts the year with inventory worth $100 and replaces the inventory when it is all sold; that is, the inventory goes to zero. If, over the course of the year, the firm sells the inventory and replaces it three times, the firm is said to have an inventory turnover of three times.
As a general rule, turning over inventory faster is a good thing because it means that the firm is doing a good job of minimizing its investment in inventory. Nevertheless, like all ratios, inventory turnover can be either too high or too low. Too high of an inventory turnover ratio may signal that the firm has too little inventory for its customers and could be losing sales as a result. If the firm’s inventory turnover level is too low, it could mean that management is not managing the firm’s inventory efficiently or that an unusually large portion of the inventory is obsolete or out of date. In sum, inventory turnover that is significantly lower or significantly higher than that of competitors calls for further investigation.
Based on the inventory turnover figure, and using a 365-day year, we can also calculate the days’ sales in inventory, which tells us how long it takes a firm to turn over its inventory on average. The formula for days’ sales in inventory, along with the 2014 calculation for Diaz Manufacturing, is as follows:
(4.4)
Note that inventory turnover in the formula is computed using Equation 4.3. On average, Diaz Manufacturing takes about 140 days to turn over its inventory. Generally speaking, the smaller the number, the more efficient the firm is at moving its inventory.
Alternative Calculation for Inventory Turnover
Normally, we determine inventory turnover by dividing cost of goods sold by the inventory level at the end of the period. However, if a firm’s inventory fluctuates widely or is growing (or decreasing) over time, some analysts prefer to compute inventory turnover using the average inventory value for the time period. In this case, the inventory turnover is calculated in two steps:
• 1.We first calculate average inventory by adding beginning and ending inventory and dividing by 2:
• 2.We then divide the cost of goods sold by average inventory to find inventory turnover:
Note that all six efficiency ratios presented in the chapter (Equations 4.3 through 4.8) can be computed using an average asset value. For simplicity, we will generally use the end of the period asset value in our calculations.
Accounts Receivable Turnover and Days’ Sales Outstanding
Many firms make sales to their customers on credit, which creates an account receivable on the balance sheet. It does not do the firm much good to ship products or provide the services on credit if it cannot ultimately collect the cash from its customers. A firm that collects its receivables faster is generating cash faster. We can measure the speed at which a firm converts its receivables into cash with a ratio called accounts receivable turnover; the formula and calculated values for Diaz Manufacturing in 2014 are as follows:
(4.5)
The data to compute this ratio is from Diaz’s balance sheet and income statement (Exhibits 4.1 and 4.2). Roughly, this ratio means that Diaz Manufacturing loans out and collects an amount equal to its outstanding accounts receivable 5.11 times over the course of a year.
In most circumstances, higher accounts receivable turnover is a good thing—it means that the firm is making fewer sales on credit and collecting cash payments from its credit customers faster. Such credit is a customer incentive that is used to promote sales, but it can be expensive. As shown in Exhibit 4.3, Diaz’s collection speed slowed down slightly from 2012 to 2014. This may be a cause for management concern for at least three reasons. First, Diaz’s system for collecting accounts receivable may be inefficient. Second, the firm’s customers may not be paying on time because their businesses are slowing down due to industry or general economic conditions. Finally, Diaz may be extending credit to customers that are poor credit risks. Making a determination of the cause would require us to compare Diaz’s accounts receivable turnover with corresponding figures from its competitors.
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