Measuring Company Efficiency To Maximize Profits

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 the moneys they're owed.

Efficiency ratios determine how productively a company manages its assets and liabilities to maximize profits. Shareholders look at efficiency ratios to assess how effectively their investments in the company are being used. Some of the most commonly considered efficiency ratios include inventory turnover, accounts receivable turnover, accounts payable turnover and the cash conversion cycle (CCC). In this article, we'll take you through the processes step by step.

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 products they have manufactured or purchased from suppliers. Inventory turnover measures how quickly the company is moving merchandise through the warehouse to customers.

The inventory turnover ratio gives an indication of how many times a company sells and restocks its inventory over a given period of time, or how many days on average it takes the company to sell out its inventory. Higher inventory turnover rates are generally considered favorable, evidencing brisk sales, but excessively frequent turnover may indicate inefficient ordering or that a company may be having difficulty meeting demands for orders on a timely basis.

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.

$\text{Inventory Days = 365 Days}\div\left(\text{Average Cost of Goods Sold}\div\text{Average Inventory}\right)$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" or "days sales of inventory" ratio (DSI).

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. (For more details, see How do I calculate the inventory turnover ratio?)

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 rising 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.

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 due 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 merchandise and equipment, salaries, loans and, best of all, dividends and growth opportunities.

Accounts receivable turnover ratio provides an indication of a company's efficiency at collecting sales revenues on a timely basis. Companies using payment terms of 30 to 60 days and being paid on time yield accounts receivable turnover ratios between 6 and 12. Low ratios can indicate payment-collection problems.

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

$\text{Receivables Days = 365 Days}\div\left(\text{Revenues}\div\text{Average Receivables}\right)$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.

The accounts payable turnover ratio is a short-term liquidity metric that gauges how efficiently a company manages its outflows of cash, especially in relation to paying its creditors.

Higher ratios, indicating the company can keep cash on hand longer, are generally considered preferable. However, a company must balance this with maintaining good credit and avoiding late payment fees.

The Cash Conversion Cycle combines the measurements of inventory, accounts receivable and accounts payable turnover rates to give a more complete summary of a company's overall proficiency at managing its inflows and outflows of cash. A faster CCC shows better cash management. If a company's CCC is problematically slow, the problem can usually be identified within days inventory outstanding, days receivable outstanding or days payable outstanding.

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. The differences are dramatic. 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.

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.

Finding out where a firm's cash is tied up can help shed light on how efficiently a company is being managed, utilizes its assets and handles liabilities. Of course, it takes time and effort to extract the information from corporate financial statements. However, doing the analysis will certainly help you find which companies are worthy of investment. Just bear in mind that having one or several high-efficiency ratios does not necessarily mean a company is making money. Efficiency ratios can indeed provide an indication of profitability, but even though a company may be well-managed and operating efficiently, it does not automatically translate into turning a profit.

How can an investor determine the efficiency of a company's working capital management?