You will be able to read a balance sheet for the capital a business ties up and the claims ahead of shareholders.
In the FY4 downturn, Larkspur's revenue fell 15% but its inventory barely moved. Parts made for customers' machines sat in the warehouse while orders were pushed back. The income statement showed lower profit. The balance sheet showed something the income statement couldn't. S$72 million of the company's money was tied up in stock for customers who'd gone quiet. A balance sheet tells you how much capital a business needs to run and who has a claim on it ahead of you.
Figures are made up and in S$ millions.
Working capital, in the sense analysts use for modelling, is receivables plus inventory minus payables. Receivables are sales not yet paid for by customers. Inventory is materials and products not yet sold. Payables are bills the company hasn't yet paid its own suppliers. The first two tie up cash. The third provides it.
Larkspur at the end of FY5 had receivables of 80, inventory of 70 and payables of 45, so working capital was 105, about 26% of its revenue of 400. Every extra dollar of sales needs roughly 26 cents more of working capital, which is cash the business has to find before it sees the profit. Lesson 7.6 uses that ratio in the forecast.
Totals hide the detail, so analysts convert each line into days.
Receivable days are receivables divided by revenue, times 365: 80 over 400, times 365, is 73 days. On average customers take about ten weeks to pay. Inventory days use cost of sales instead of revenue, because inventory is held at cost: 70 over 280, times 365, is about 91 days. Payable days also use cost of sales: 45 over 280, times 365, is about 59 days.
A year earlier, in the downturn, the figures were about 76 receivable days, 104 inventory days and 61 payable days. So as orders recovered, inventory days fell by about two weeks, which released cash.
Rising days are the thing to watch. Receivable days climbing over several years can mean customers are paying more slowly, or that sales are being booked on generous terms to hit targets. Inventory days climbing can mean products aren't selling. Payable days climbing can mean the company is stretching its suppliers because it's short of cash. None of these proves a problem. Each is a question for the annual report and the next results call.
When a company buys another business for more than the fair value of its identifiable net assets, the difference sits on the balance sheet as goodwill. Larkspur paid more for its coatings business than the assets were worth on paper, and 30 of goodwill remains.
Under SFRS(I) and IFRS, goodwill isn't written down a little each year. It's tested for impairment at least once a year: management forecasts the cash the acquired business will produce, discounts it, and compares the result with the carrying value. If the forecast falls short, the goodwill is cut and the loss goes through profit.
That's why goodwill impairment shows up so often as a key audit matter, as it did for Larkspur in lesson 6.3. The test depends on management's own forecast, and management has every reason to be optimistic about a deal it made. A large goodwill balance against a weak segment, as with Larkspur's coatings, is a write-down that may simply be waiting for a bad year.
Shareholders own what's left after everyone else is paid. Bank debt, bonds and lease liabilities all rank ahead of them.
Larkspur owes 60 of bank debt and 20 of lease liabilities, against cash of 60. Net debt is debt minus cash. Including leases, it's 60 plus 20 minus 60, which is 20. Excluding leases, it's zero. Choose one definition and keep to it, because leases, as lesson 6.4, Notes to the accounts: revenue, segments, leases and debt, explained, are a real obligation even though some companies and data providers leave them out.
Net debt to EBITDA compares what the company owes with roughly a year's cash earnings before interest, tax and depreciation. Larkspur's EBITDA in FY5 was 80: operating profit of 56 plus depreciation of 24. Its net debt to EBITDA is 20 over 80, or 0.25 times. Its bank covenant allows up to three times. Many lenders start to worry well before that level for a cyclical company, because EBITDA can fall fast in a downturn.
Interest cover is operating profit divided by interest expense: 56 over 4, which is 14 times. Larkspur earns its interest bill fourteen times over.
Both ratios are comfortable for Larkspur in FY5, so run them through the downturn year as well. In FY4, net debt including leases was 42 against EBITDA of about 64, roughly 0.7 times, and operating profit of 40 covered interest of 4 ten times over. Weaker, and still safe. For a cyclical company the bad year is the real test, because a company at three times EBITDA in a good year can be at six times when earnings halve, and that's where covenants bite.
Calculate receivable, inventory and payable days for five years from your company's accounts, and net debt to EBITDA for each year, so you can see the bad years as well as the good.
Calculate receivable, inventory and payable days for five years and net debt to EBITDA for your company.
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