What Drives Operating Metrics? Simple Things I Forget (#investing, #finance)

A few weeks ago I was looking over the Morningstar.com tearsheets for about forty different mid-to-large-cap companies on a small assignment for an acquaintance. The project involved looking at the major financial metrics for a number of companies as provided on these tear sheets and trying to develop a quick, summary opinion of their business performance over the last decade.

On the one hand, it was just a bunch of series of numbers, going up, going down, sometimes not going much of anywhere at all. Depending on the metric being examined, this might be good, bad or ugly. But, if you looked a little closer, you might realize that even these simple numbers could tell a larger story about the business and what was happening to it or with it over time. You see, every financial metric I looked at was merely the result of the interplay of two, three, four or more other numbers “beneath” it. As one or some of these numbers changed, so, too, did the “top level” metric I was looking at on the tearsheet.

I spent a considerable amount of time, specifically, looking at the income and cash flow metrics, the reason being that most of these were large, stable and often growing enterprises– the balance sheet is always useful but with these kinds of companies what happens to income and cash flows over time can be an even more exciting and compelling story.

When analyzing an income statement, there are three key profit measures that investors like to look at: gross, operating and net profits. Additionally, when examining the balance sheet for the cash generating abilities of the business, there are two key measures investors focus on: operating and free cash flows.

If you’re like me, you sometimes forget the simple relationships these metrics have with other financial statement figures in terms of how one number drives another. Or maybe you’re new to studying financial statements and are looking for a handy reference. Either way, the following information may be helpful for you.

Let’s start with the income statement metrics:

  • Gross Profit, equal to total revenues minus the costs of goods sold; because of this, higher gross profits are arrived at by either increasing the price at which goods are sold (making revenues larger) or decreasing the costs of the goods sold (making COGS smaller)
  • Operating Profit, equal to gross profit minus the expenses incurred in running the business, such as paying sales costs (marketing, advertising, commissions), employees salaries and bonuses and corporate administration (SG&A), using PP&E and incurring depreciation or amortization expense and any costs related to the development of new products and services (R&D); because of this, higher operating profits can be achieved by lowering R&D expenses, lowering SG&A expenses, lowering D&A expense or raising gross profits by one of the methods discussed previously
  • Net Profit, equal to operating profit minus interest expense and tax liability; because of this, higher net profits can be achieved by minimizing tax expenses, reducing financial leverage and the interest burden that comes with it (or by refinancing existing debt at a lower rate), or raising operating profit by one of the methods discussed previously

If you are examining a series of income results for a company over a period of years and notice a variance in any of these primary profit metrics, look to the component drivers of those metrics to help explain the reason for the variance.

Now let’s take a look at the two cash flow items:

  • Operating Cash Flow, equal to net income plus the addition of all non-cash expenses (such as depreciation and amortization) and the net change in working capital; increases in operating liabilities increase operating cash flow, increases in operating assets decrease operating cash flow, higher D&A charges increase operating cash flow and of course, a higher starting net income increases ultimate operating cash flow
  • Free Cash Flow, equal to operating cash flow minus total capital expenditures; the less the company invests in maintenance and growth expenditures of capital now, the higher free cash flow will be, but if not enough is spent to protect the business’s earnings power and market position, long-term free cash flow generation abilities may become impaired

The operating cash flow metric is important to look at because it tells you whether the company actually generates a positive cash return on its investments from its main business activities. Companies that can’t generate cash from their operations over time are destined to financial and economic failure. Changes in operating cash flow when compared to changes in net earnings can give a window into how the company is generating profit– through business and market management, or through accounting manipulation and trickery.

The free cash flow metric is valuable because it shows the resources the company generates, beyond those needed to grow and maintain its current capital investments, which can be used to reduce indebtedness or reward shareholders with buybacks and dividends. Companies with relatively high and sustainable free cash flow-generating characteristics can be rewarding investments over long periods of time if they can be bought at low multiples to their normalized free cash flow.

There is a lot more to financial analysis than this. There are hundreds of ratios, metrics and other financial data you can use to measure the operating efficiency and management talent of companies you are interested in. This is not meant to be a comprehensive review. It’s possible I even missed a few items of note with regards to the metrics I singled out.

But sometimes I forget these simple truths when trying to think deeply about businesses I am analyzing, so I wanted to leave this little note for myself in case I ever get stuck and forget the obvious again. With any luck, this information will help someone else out in a similar fix, or else it will prove to be a stepping stone for a beginner making their first inquiry into the world of business analysis.

Are Cash-Flush Corporate Balance Sheets Hiding Stagnating Operating Efficiencies? (#workingcapital, #ZIRP)

In an article entitled “Too Much of a Good Thing” from CFO.com, we learn that American businesses have become less efficient with their use of working capital over the last year:

Days working capital (DWC) — the number of days it takes to convert working capital into revenue — did decrease marginally in 2011, from 37.7 days to 37 days. But REL downplays the improvement, attributing it in part to the companies’ 13% average revenue growth. “To have a 1.9% decrease is a positive, but not by a lot,” says Prathima Iddamsetty, senior manager of operations, research, and marketing at REL, a working capital consultancy.

Cash on hand across the group of surveyed companies, dubbed the REL U.S. 1,000, increased by $60.3 billion in 2011, helped in part by companies taking advantage of low interest rates to issue more debt, up by a record $233 billion year-over-year. Those companies now have a staggering $910 billion in excess working capital, including $425 billion in inventory, according to REL. “Way too much cash is being left on the table and not being put toward growth objectives,” says Iddamsetty.

But why does it matter?

Indeed, cash is still king for the REL U.S. 1,000. This is clearly evidenced by the $60 billion increase in cash on hand and the $233 billion increase in debt in 2011. Over a three-year period, cash on hand was $277 billion and accumulated debt $268 billion.

But using debt instead of efficient working capital management to get more cash into the bank account “comes with a long-term cost: eventually they will have to pay [the debt] down,” points out Ginsberg. “They’ll also have to generate a return on their existing assets that exceeds the interest rate, which is not what we’re seeing.”

It’s better to tap working capital as a funding source for long-term growth strategies, says Ginsberg. REL Consulting cites top performers in a broad range of industries, leveraging working capital to open up new businesses in emerging markets with growing consumer demand, for instance.

“Top performers have very tight manufacturing timetables and inventory management practices, in addition to strict collections and payment systems that are standardized across all locations,” says Michael K. Rellihan, an associate principal at REL. “The cash they generate from this high level of working capital efficiency is then applied to the growth agenda. Long-term, the result is a powerful benefit to the bottom line.”

“Only process improvements will provide sustainable cash flow benefits,” adds REL’s Sparks. “This requires working more closely with customers, getting better information to suppliers, and improving demand forecasting. You need to have an underlying process in place to manage working capital on a day-to-day basis; if not, it will be difficult to sustain.”

In other words, the growth in corporate debt and the resulting excess cash on the balance sheet gives the illusion of financial and business health in the short-term, when in the long-term these companies still must find ways to improve operating efficiencies and thereby generate profit. Ironically, even as the cost of debt in a zero-interest rate policy environment falls, this is getting harder and harder to do because there are fewer and fewer genuine opportunities to drive real growth and expand the top line while maintaining operating efficiency. It makes you wonder how much of this working capital problem is a symptom of our ZIRP-economy.

There was also a helpful chart showing the state of working capital efficiency by industry that can give you a quick high-level look at winners and losers in terms of working capital management.