You will be able to read a balance sheet for the capital a business ties up and for the claims that rank ahead of shareholders.
Larkspur, a fictional company, makes parts that go into its customers' machines, so its sales rise and fall with theirs. In FY4, a downturn year, its revenue fell 15% but its inventory barely moved, because finished parts sat in the warehouse while customers pushed their orders back.
Larkspur's income statement for FY4 showed lower profit. It did not show the S$72 million tied up in stock for customers who had gone quiet, which the balance sheet does. A balance sheet tells you how much capital a business needs to run, and who has a claim on that business ahead of shareholders. The Larkspur figures that follow are invented examples, in S$ millions.
Analysts building a model use working capital to mean receivables plus inventory minus payables. Receivables are sales that customers have not yet paid for. Inventory is materials and products not yet sold. Payables are bills the company has not yet paid its own suppliers. Receivables and inventory tie up cash, and payables provide it.
For FY5, Larkspur's receivables were 80, inventory 70 and payables 45. Working capital is 80 + 70 - 45 = 105. Revenue was 400, so working capital as a share of revenue is 105 / 400, about 26%.
That ratio tells you how much extra working capital each extra dollar of sales needs. At Larkspur, each extra dollar of sales needs roughly 26 cents more working capital, and that cash has to be found before the profit on the sale arrives. Lesson 7.6 uses this 26% in the forecast.
A working capital total hides detail, so analysts convert each line into days. The three formulas are:
Receivable days = receivables / revenue x 365 Inventory days = inventory / cost of sales x 365 Payable days = payables / cost of sales x 365
Inventory is held at cost, so inventory days use cost of sales rather than revenue. Payable days use cost of sales too.
Larkspur's FY5 cost of sales was 280. Receivable days are 80 / 400 x 365 = 73 days, about ten weeks between a sale and the cash. Inventory days are 70 / 280 x 365, about 91 days. Payable days are 45 / 280 x 365, about 59 days.
In FY4 the same measures were about 76 receivable days, about 104 inventory days and about 61 payable days. As orders recovered in FY5, inventory days fell by about two weeks, and falling inventory days release cash.
Rising days are what to watch. Receivable days rising over several years can mean customers are paying more slowly, or that sales are being booked on generous terms to hit targets. Rising inventory days can mean products are not selling. Rising payable days can mean the company is stretching its suppliers because it is short of cash. None of these proves a problem. Take each one as a question to the annual report and to the next results call.
Goodwill arises when a company buys a business for more than the fair value of its identifiable net assets. The difference sits on the balance sheet as goodwill. Larkspur bought a coatings business for more than its assets were worth on paper, and 30 of goodwill from that deal remains.
Under SFRS(I) and IFRS, goodwill is not written down a little each year (it is not amortised). It is tested for impairment at least once a year instead. Management forecasts the acquired business's cash, discounts that forecast, and compares the result with the carrying value. If the discounted forecast falls short, goodwill is cut by the shortfall and the loss goes through profit.
The test relies on management's own forecast, and management has reason to be optimistic about a deal it made. For this reason goodwill impairment often appears as a key audit matter, as it did for Larkspur in lesson 6.3. Coatings is a weak segment for Larkspur, and a large goodwill balance against a weak segment may be a write-down waiting for a bad year.
Shareholders own what is left after everyone else is paid. Bank debt, bonds and lease liabilities all rank ahead of them.
Net debt is debt minus cash. You can calculate it including or excluding leases; pick one definition and stick to it. Some companies and data providers leave leases out, but leases are a real obligation, as lesson 6.4, "Notes to the accounts: revenue, segments, leases and debt", explained.
Larkspur has bank debt of 60, lease liabilities of 20 and cash of 60. Net debt including leases is 60 + 20 - 60 = 20. Excluding leases it is 60 - 60 = 0.
Net debt to EBITDA compares what the company owes with roughly one year of cash earnings before interest, tax and depreciation. Here EBITDA is operating profit plus depreciation. Larkspur's FY5 operating profit was 56 and depreciation 24, so EBITDA is 56 + 24 = 80, and net debt to EBITDA is 20 / 80 = 0.25 times. Its bank covenant allows up to three times. Many lenders worry well before the covenant limit for a cyclical company, because EBITDA can fall fast in a downturn.
Interest cover is operating profit divided by interest expense. With FY5 interest expense of 4, Larkspur's interest cover is 56 / 4 = 14 times, so both debt ratios are comfortable.
For a cyclical company, the bad year is the real test of these ratios. A company at three times EBITDA in a good year can be at six times when earnings halve, which is where covenants bite. So rerun both ratios for the downturn year. In FY4 Larkspur's net debt including leases was 42 and EBITDA about 64, giving roughly 0.7 times. Operating profit was 40 against interest expense of 4, so interest cover was 40 / 4 = 10 times. Larkspur was weaker in FY4 but still safe.
Now do this for your own company. From its accounts, calculate receivable, inventory and payable days for five years, and net debt to EBITDA for each year, so you can see the bad years as well as the good.
Work out receivable, inventory and payable days for five years, and net debt to EBITDA, for your company.
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