TOOL E9
The “Asset Management” component of financial risk analysis provides insight into whether assets are being used efficiently to optimise profit margins in the business. In general, this depends on a client’s ability to turn around current assets quickly; use fixed assets intensively; and make an optimal return on financial assets. This tool helps you understand and interpret the non-financial reasons that drive the metrics associated with “Asset Management”; identify one-off factors; consider accounting policies that impact the reported numbers; and be mindful of internal spreading errors that may distort these metrics.
Asset Conversion Cycle (ACC)
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| ACCOUNTS RECEIVABLE DAYS Av. Accounts Receivable x 365 days / Sales | Increasing receivable days may be a result of: • Customers being unable to pay • Customers being unwilling to pay because of performance risk • One-off or structural change in the terms of trade • Uncollectible receivables not being provided for, due to pressure to produce good result. Decreasing receivable days may result from: • A squeeze on receivables to help the company’s tight cash situation – check whether there are other warning signs • Increased bargaining power • Improved collection efficiency | • One-off change in the terms of trade • Sales higher than usual before year-end • Factoring / securitisation • Provisioning policy • Change in Sales tax (VAT) • Change in mix of credit and cash sales | • Has there been a change in provisioning policy? • Have sales been recognised early distorting the accounts receivable? • Tool: Accounting Policies • Tool: Creative Accounting | • Are amounts due from group included in accounts receivable? • Are all receivables trade? • Be clear whether the trends are based on year end or average numbers. Average understates the trend. Year end is subject to yearend fluctuations |
| INVENTORY DAYS Average Total Inventory x 365 days / Cost of Goods Sold | Drill down to the trend in finished goods, work in progress and raw materials. Increasing inventory days may indicate: • A build of non-saleable inventory • Heavy WIP • Large purchase of raw materials • Preparing for delivery of large contract Decreasing inventory days may be due to: • Heavy discounting to get rid of old inventory – check the trend in gross profits. • Slowdown in production / production problems • Completion of a large contract. • Squeezing inventory to help in a tight cash situation – check for other warning signs | • Build up of inventory – new product / obsolete inventory • High purchase of (cheap) raw materials • Change in price levels of raw materials • Unusually big contract near the year end • Write down of inventory | • Has the method of inventory valuation changed? • Does cost of sales include depreciation or not? For all ACC ratios Care re concentration Care average figures may understate the trend. Think about year-end trend which may be subject to yearend fluctuations. | • Check for changes / errors / inconsistencies in cost of sales (see Gross Margin in previous tool) • Have payments in advance been shown as a separate item? • Be clear whether the trends are based on year end or average numbers. Average understates the trend. Year end is subject to yearend fluctuations |
| ACCOUNTS PAYABLE DAYS Av. Accounts Payable x 365 / Cost of Sales | • Increasing, because of good bargaining power or pressure on cash flow • Reducing, because of pressure from suppliers or taking advantage of early payment discounts. Consider are the suppliers being preferred to the Bank? One-off structural change in the terms of trade | • One-off change in the terms of trade • Purchases higher than usual at year end • Change in mix of cash and credit purchases • Changes in sales tax (VAT) | • Impact of inventory valuation on cost of sales • Is depreciation included in cost of sales Tool: Accounting Policies Tool: Creative Accounting | • Have amounts due to group been booked as accounts payable? • Check for changes / errors in cost of sales (see Gross Margin in previous tool) • Are all payables trade? • Be clear whether the trends are based on year end or average numbers. Average understates the trend. Year end is subject to yearend fluctuations |
| NET WORKING ASSETS/SALES (Inventory + Receivables – Payables) / Sales | The ratio indicates the length of ACC and sensitivity of ACC cash requirements to changes in sales. For example, a ratio of 10% means that for every additional $100 of sales, the client will need an extra $10 dollars to finance ACC—provided the ACC remains stable. Because we are comparing inventory and payables to sales (not cost of sales) the trend will be distorted if gross margins vary An increasing ratio trend indicates that: • ACC is becoming longer. • ACC will consume more cash than usual if sales grow. • ACC will generate more cash than usual if sales decline. A decreasing ratio trend indicates that: • ACC is becoming shorter. • ACC will consume less cash than usual if sales grow. • ACC will generate less cash than usual if sales decline. | See Accounts Receivables, Inventory, and Accounts Payable Days ratios above. | See Accounts Receivables, Inventory, and Accounts Payable Days ratios above. | See Accounts Receivables, Inventory, and Accounts Payable Days ratios above. |
| ASSET REPLACEMENT Capex (PPE) / Depreciation Expense • The intensity of tangible fixed asset utilisation is usually best measured without financial ratios if possible • Use an industry specific capacity ratio like occupancy rates for hotels etc • Remember FA/ Sales may be distorted by depreciation. • Check whether intangible assets add value to the business (i.e. operating margins) | If the amount invested in capital expenditure is consistently less than depreciation, this may mean: • Business is not in an investment phase and replacement is not required. • Assets are being replaced off balance sheet through operating leases • Replacement Capex is not being undertaken at the required level If the capital expenditure is consistently higher than depreciation, this may mean: • Business is investing in assets • Assets off balance sheet on operating leases are being replaced with owned assets. Check how assets are being funded as this may lead to a funding gap. | • Major factor will be whether the business undertakes Capex on a regular basis or in batches. • When new Capex is done, there may be a time lag before depreciation is charged. • If the business has changed since depreciated assets were bought, the ratio could be misleading. | • Check that the depreciation relates only to the type of plant and equipment. • Check history of book gains and losses to form a view on whether depreciation policy is conservative or optimistic. • Revaluations may increase depreciation. | • Has depreciation been separately identified from above and below gross profit? • Check that change in net fixed assets is not confused with gross Capex. |
Return on Financial Assets
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| RETURN ON ASSOCIATE INVESTMENTS Income (Losses) from Associates / Investments in loans to Associates For other financial investments make sure (wherever possible) that you compare earnings with the relevant asset | • Establish how closely related the activities of the associate company / joint venture are to the investor. Is it a standalone investment or integral part of their operations? • If standalone then if there is a declining trend could the client divest and reinvest more profitably elsewhere? • If integral to operations, to what extent does the return measure the strategic importance of the associate? • If there are losses then it is clear why the operation must continue and how much cash / support will be needed by the investor? | • Any one-off items in the financial statements of the associate company? • Deconsolidation of a previously consolidated company. • Consolidation of associates. | • Are the associates accounted for at cost or by equity accounting? • If cost accounting, is there a possibility of hidden losses? How does the cost compare to the net worth of the associate? • If equity accounting, what is the quality of earnings? Are they cash or non-cash? Is there hidden leverage | • Is it clear whether income is cash or non-cash? • Are all potential off balance sheet contingencies / commitments to the associate included? |
