01 Aug 2015 00:03

Tags annual_report financial_statements liquidity

This will be a new blog series that will walk through the steps of performing a detail financial analysis when selecting a stock to buy.

Buried in a company’s Annual Report you are likely to find their financial statements. The financial statements are divided into three sections; Income Statement, Cash Flow Statement, and Balance Sheet Statement. If you are new to investing, seeing all of these financial numbers and terms may seem intimidating. Yet, hopefully this blog series can help simplify what numbers to extract and how to analyze those using financial ratios.

At the end of this series I will share the spreadsheet used throughout the exercise which will include all of the formulas to calculate the ratios and on which statement to find the values to populate.

When analyzing a Company’s financial statement we will split the analysis into 4 parts:

- Liquidity
- Profitability
- Long Term Credit Risk
- Stock Holder Value

Before we kick this series off there are a few basic accounting concepts you need to understand before we continue.

- Revenue and cash are not the same thing. Revenue is recorded when a customer takes possession of a product and not when they receive payment. Here is a simple example;

You receive a mail order product in December worth $50 but do not pay cash. You receive a bill for the product in January and pay in full the $50 bill in February. In this scenario a Company records $50 of revenue for the month of December and not in February when it received payment because you took possession of the product in December.

- Revenue and Sales are interchangeable terms
- Income and Earnings are interchangeable terms
- Do not use generic rules of thumb to determine if a ratio is good or bad. Ratios will vary from industry to industry. For example, would you expect an aircraft manufacturer to have an inventory turnover ratio the same as a toilet paper manufacturer? I think people buy toilet paper on a more routine basis than they would buy airplanes.
- When performing an analysis of a company always compare it to their top competitor to help determine if a ratio in a given industry is normal, good, or bad.

With these concepts out of the way let us start reviewing Liquidity and ratios to evaluate a company.

The formal definition of liquidity refers to a company’s ability to meet its continuing obligations. A simpler way to state this would be “How capable is the company to pay its bills and make debt payments”.

This is no different than valuating how well capable you are paying your monthly bills based on your salary, savings, and investments. And to help us understand what is meant by “capable” we have liquidity ratios.

**Current Ratio** – A measure of short term debt paying ability. The current ratio is calculated by dividing total current assets by total current liabilities. The result of the ratio will tell you how many times assets are more or less than liabilities.

*Both items can be found on the Balance Sheet Statement.*

**Current Ratio = Total Current Assets / Total Current Liabilities**

**Quick Ratio** – The quick ratio is similar to the current ratio but instead does not use total current assets but only the most liquid assets (cash, accounts receivable, and marketable securities). Quick ratios are most useful for companies with slow moving merchandise like trains, real estate or aircraft.

*All items can be found on the Balance Sheet Statement.*

**Quick Ratio = Cash + Marketable Securities + Accounts Receivable / Total Current Liabilities**

**Cash Flows from Operations to Current Liabilities** – This calculation refers to a company’s abilities to pay its obligations rom normal operations. This ratio calculated by dividing Cash Flow from Operations divided by Current Liabilities.

*Cash flow from operations can be found on the Cash Flow Statement and current liabilities can be found on the Balance Sheet Statement.*

**Cash Flows from Operations to Current Liabilities = Net Cash Provided by Operating Activities / Total Current Liabilities**

**Receivables Turnover Rate** – The rate of how many times a year that a company can convert receivables into cash. The rate is calculated by dividing Net Sales (or Revenue) by Accounts Receivable.

*Net sales can found on the Income Statement and accounts receivable can be found on the Balance Sheet Statement.*

**Days to Collect Accounts Receivable** - This calculation represents how many calendar days it takes to convert a receivable into cash. This is calculated by dividing Days of the Year by the Receivables Turnover Rate.

**Days to Collect Receivables = 365 / Receivables Turnover Rate**

**Inventory Turnover Rate** – The rate of how many times a year that a company can sell and replace their inventory. The rate is calculated by dividing Costs of Goods Sold by Average Inventory.

*Cost of goods sold (or Cost of Sales) can found on the Income Statement and average inventory can be found on the Balance Sheet Statement.*

**Inventory Turnover Rate = Cost of Goods Sold / Average Inventory**

**Days to Sell Inventory** – This calculation represents how many calendar days it takes to sell and replace inventory. This is calculated by dividing Days of the Year by the Inventory Turnover Rate.

**Days to Sell Inventory = 365 / Inventory Turnover Rate**

**Operating Cycles** - The number of days that inventory can be converted into cash (not revenue). This is calculated by adding Days to Collect Receivables and Days to Sell Inventory.

**Operating Cycles = Days to Collect Receivables + Days to Sell Inventory**

**Free Cash Flow** - Represents the cash flow available to management, after meeting obligations, to allow for investment. If free cash flow is negative it represents that the company did not generate enough cash from operations to meet obligations. This is calculated by summing Net Cash Provided by Operating Activities, Cash used for Investing Activities, and Dividends.

*All three items can be found on the Cash Flow Statement*

**Free Cash Flow = Net Cash Provided by Operating Activities + Cash used for Investing Activities + Dividends**

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

Which company had overall better liquidity numbers? Both companies scored similar but I’d have to give a slight edge to JNJ because it is much more efficient at turning over inventory and converting it into sales and cash and creating a lower operating cycle.

But there are questions that need to be investigated with JNJ with its negative 2014 Free Cash Flow. Looking historically at the free cash flow it is not hard to see in 2014 a spike of an additional $8B towards investments over its average of $4B for a total of $12B. This may not be a bad thing but at least it is a clue to conduct further research as to what JNJ spent $12B on.

Though JNJ has a slight edge there is no clear winner in this round as both companies demonstrate strong liquidity measures.

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