A few days back we shared with you ‘4 important ratios to look at when investing in any stock’. We talked about, ROCE, ROE, Interest coverage, debt-equity. In case you missed it, you can check it here – LINK
Today, we will discuss some important ratios with respect to the cash flows of the company. As they say, ‘Revenue is vanity, profit is sanity and cash is reality’.
In our view, no fundamental analysis on any company can ever be complete without understanding the cash flows of the company.
Before that, if you are interested in investing in a pharmaceutical company which has made an extremely complex and poisonous material from scratch (with a worldwide market potential of Rs 27,000 crore +) and is the only Indian maker, you can read about it here - LINK
Just like last time, to understand the ratios easily, for the next 10 minutes assume yourself to be a businessman with a business wherein your annual sales are Rs 120 crore. For the same you consumed Rs 60 crore of raw material and finished goods.
To ensure your sales are not disrupted for the coming year, you have Rs 30 crore of inventory and Rs 10 crore is pending in terms of payment to suppliers (payables). Further, out of Rs 120 crore sales, you are yet to receive Rs 20 crore from your customers (debtors).
Debtor days – You may have come across this term often and may not have understood it; however, as you will notice from the above example, the calculation and the understanding of the same is quite easy.
Debtor days is used to calculate the credit period that the company gives its clients. Ideally, you would want your customer to pay in advance or as early as possible. At the same time, the customer in general would like to defer his payments.
So, in the above example, you are doing sales of Rs 10 crore per month and as you are yet to receive Rs 20 crore from your customers, the debtor days for your business are 60 or 2 months; which means on an average you give 60 days to your customers to make the payment.
Formula = [Accounts receivable/ Annual Sales] * 365 days
Why high debtor days or rising debtor days can be a cause for concern – As mentioned above, cash is reality and till you get the money from the customer, there remains a possibility that for some or the other reason the customer might default.
Also, rising debtor days could indicate that the business is getting extremely competitive and in order to realize sales, you are offering higher credit period to customers which again increases the risk of bad debts.
Inventory days – The calculation for inventory days is again as simple as debtor days. The idea behind calculating inventory days is to determine how long the raw material/finished goods remain stuck in your factory/warehouse/store before you are able to convert them to sales.
Here again, in general you would want to sell off your products as soon as possible and realize cash from the sales. Unless, you deal in products (liquor, rice, etc) where ageing can help you charge a premium or where holding additional inventory gives you some competitive advantage with your customer (Example: low downtime).
In the above example, as you are holding Rs 30 crore of inventory against an annual requirement of Rs 60 crore, the inventory days for your business are 183 or 6 months.
Formula = [Inventory/ Cost of goods sold] * 365 days
One can also calculate Inventory days on the basis of sales and the formula would change to [Inventory/ Annual Sales] * 365 days
Why high inventory days or rising inventory days can be a cause for concern – Unless there’s a specific business requirement that leads to competitive advantage, in general you would want your inventory days to be on the lower side, because otherwise you run the risk of obsolescence, ruin, etc.
Similarly, rising inventory days could potentially mean that the product isn’t moving fast enough or lack of demand.
A lot of companies work on the concept of just-in-time inventory so as to not block their own capital and ensure a very strong supply chain.
Payable days – Payable days help determine the time you are taking as a businessman to make payments to your supplier.
In the above example, you consumed Rs 60 crore of goods for the whole year and your outstanding payment to suppliers is Rs 10 crore.
So, the payable days will be 61 or 2 months.
Formula = [Accounts payable/ Cost of goods sold] * 365 days
Depending on the nature of the business, competitive positioning in the industry and the supply chain, high payable days could indicate that you have a bargaining power with your suppliers.
At the same time, if the business positioning is not good, rising payable days could mean that the business is facing issues in making payments to the supplier and the supply may soon cut off.
Cash conversion cycle – The cash conversion cycle (CCC) helps us determine the number of days it takes a company to convert cash into inventory, and then back into cash via the sales process. The shorter a company’s cycle, the less time a company has cash tied up in its accounts receivable and inventory.
Formula = Debtor days + Inventory days – Payable days
To understand it better, an FMCG company with major brands may probably have a negative cash conversion cycle.
How – There’s a strong pull for brands so distributors may pay in advance (-ve debtor days). Company may not maintain very high inventory because of its strong supplier base and at the same time it may also have some leverage in terms of higher credit days with its suppliers.
Hope this post will help you analyse the companies you are tracking better.