With so many tech companies gasping under mountains of surplus widgets, investors have to be able to separate out the ailing from the moribund. A little thoughtful ratio analysis can help by alerting stockpickers to the severity of inventory problems -- and also to the specter of deadbeat customers.
Part 1: Debt Ratios
Part 2: All About EVA
Part 3: Asset Management Ratios
In the final part of our Getting Down to Fundamentals series, we'll focus on two ratios that can clue you in to balance sheet worries: inventory turnover, which can indicate if inventory is piling up, and days sales outstanding (DSO), which shows if customers are taking a long time to pay up.
Inventory Turnover Ratio
The inventory ratio, often applied to manufacturing (including tech) and retail companies, shows how fast companies are getting their routers, thumb tacks or bananas off the shelves. Basically, high turnover is good for business. A company never wants its products to languish on the shelves, because then it's not making any money.
But it's also true that short-term inventory build-ups could be a positive sign. "An increase in the inventory turnover ratio could also signal that management expects sales to increase in the next period, and they're building up inventory today in anticipation," points out Mary Barth, an accounting professor at
For investors, the turnover ratio is most meaningful when considered over time and in the context of a company's competitors. For example, within a given industry it might be typical for a company to completely sell out of and restock its products five times a year; by comparison, a company that consistently posts a turnover ratio of three is a shameful laggard.
But be careful: you may have to probe within an industry itself to make truly meaningful comparisons. Take the retail sector, for example. "Inventory turns are going to vary greatly within the general merchandise sector," says Bill Dreher, a research analyst at
. "Wholesale clubs turn inventory very rapidly, discounters a little slower, and department stores run the gamut from lean and mean like
to other operations that might be more luxurious, with higher price points.
Inventory turnover is really going to run the gamut."
To apply the turnover ratio, let's start with bellwether retailer
, which has one of the most efficient inventory systems in the industry, according to Dreher.
The equation for the inventory ratio is simply cost of goods sold (COGS) in the most recent quarter times 4, divided by inventory in the most recent quarter (note: this more conservative approach to obtaining the turnover ratio quadruples COGS for the most recent quarter -- which probably reflects relatively slow business, in light of the economic downturn -- to arrive at an annualized number. It's a more accurate reflection of recent business trends. But you could also add up the four most recent quarters to get a trailing annual number for cost of goods sold).
For the most recent quarter, Wal-Mart's inventory ratio is 37,099 times 4, divided by 22,728, or 6.53. Turnover at Wal-Mart has actually increased slightly from a year ago, when it stood at 6.30. In other words, the company's selling stuff slightly faster than it did last year, despite the economic downturn. That impressive showing accords with the company's ongoing efficiency drive, as it attempts to tailor the selection of goods to individual stores, says Dreher (by comparison, the inventory ratio for the average broadline retail company is 5.2).
In stark contrast to Wal-Mart is
. The poster child for inventory backlog, Cisco has suffered from torpid demand; for the most recent quarter, sales were down 4% from last year. The company took an excess inventory charge of $2.2 billion for the most recent quarter. In that period, its inventory ratio was 4,035 times 4, divided by 1,913, or 8.43.
For the same period a year ago, turnover was 7.35, so Cisco appears to be turning over inventory faster now.
But remember, the latest numbers reflect a massive inventory write-off. If Cisco hadn't written off inventory in the most recent quarter, its turnover would be much lower: doing some quick, back-of-the-envelope figuring, adding $2.2 billion back to its $1.9 billion inventory number would result in turnover of only 3.9. Keep in mind, then, that inventory write-offs can make turnover appear to be better than it really is.
Days Sales Outstanding
Another handy ratio for investors looking to discern financial trends at a given company is DSO, or days sales outstanding, which offers a rough gauge of how many days it takes companies to collect payment after making a sale. It may not be easy to find a benchmark collection period for a given company, though manufacturers occasionally disclose their trade terms in financial statements. But you can still determine trends in DSO over time and compare numbers across an industry.
The formula for DSO is: receivables, or payments due, divided by, annual sales divided by 360 days. Or to calculate the quarterly ratio, use this equation: receivables divided by, quarterly sales divided by 90 days.
A rising DSO is bad, because it shows a company's taking longer than it used to to collect payments. "It can give you an indication that the company isn't going to have enough to fund their short-term obligations because the cash cycle's lengthening," says Ted Parrish, director of investments for
G.W. Henssler & Associates
A sharp increase in DSO especially bodes ill for companies that are already low on cash. In the worst-case scenario, a company may have to write off receivables that are long overdue -- a tough step for a company that's already short on money to fund operations.
But isolated jumps in DSOs may not be too much to worry about; like other financial ratios, it's crucial to put this number in
context. For example, if a company scored a big sale at the end of one month, receivables would spike up until it collected the cash later on. Though the DSO number would look like it's deteriorating, the increase in receivables would actually represent good news for the company.
We'll skip the Wal-Mart example, since analysts who follow the company say inventory turnover, which we examined above, and sales per square foot, another important indicator for retailers, are more relevant.
But let's return to Cisco, which has seen its DSO deteriorate over the last few quarters. For the most recent quarter, it's 2,471 divided by (4,728 divided by 90), or 47.0.
In other words, the average collection time of 47 days has jumped from the same time last year, when it took only 35 days. Cisco's customers -- including some beleaguered service providers -- are taking longer to pay up. "The DSO got as low as the low 30s in the first quarter of 2000 and has been steadily picking up since then. If you looked at that trend, you might have started getting worried" about the company's business a while ago, says Jay Ritter, a telecom equipment analyst at
A rising trend in DSO -- even while the stock was taking off like a rocket -- could have also tipped investors off to troubles at
. "Back in the middle of 98, its DSOs were around 75, and they progressively increased every quarter for the next five or six quarters to around 100. That was a really negative trend," says Ritter.
Since then the company has gained a measure of infamy for its practice of extending
loans to some of its customers and has had to write off massive bad loans. Upon the release of second quarter earnings, Lucent said it had been aggressively working to reduce accounts receivable that were past due and bring down its DSO. The company's DSO continues to hover in the high 90s to 100s.
Lucent's problems extend far beyond lengthy DSOs, of course. But that's the way it goes with financial ratios: they never tell the whole story, but they can offer you clues about trouble spots on the horizon.