Application of Common Size Analysis - Comparison between a Paper Manufacturer and a TV Manufacturer

We have already grasped the basics of the paper manufacturing industry and the household appliance industry. Now, let's look at individual companies from each industry respectively. We want to see if the company’s financial data and the condition of the industry are closely related.

First Look

In both industries, we will choose relatively large companies. Yet since there are lots of different household appliances in this industry, we will choose television as our target product. Now let’s take a look at the financial data of these two companies.

Before we get into the analysis, be aware that the time of the analysis is 2002, i.e. before competition in the paper manufacturing industry becomes too intense. 

Gross Profit Ratio

We can see at this time, the paper manufacturing company’s gross profit ratio is 28%. The TV manufacturing company, on the other hand, only enjoys a gross profit ratio of 15%, around half of the paper manufacturing company. (Forgot how to calculate gross profit ratio? read this.)

Why do the two companies have such different gross profit ratios?

Recall what we have discussed in the last episode, the competition within these two industries was quite different at that time. In 2002,

paper manufacturing industry was in a stage of rapid growth without intense competition. The household appliance industry at that time had

already entered the stage of fierce competition. The different competitive environments made a huge difference in the gross profit gratios in the two companies.

Next we are going to look at four financial numbers, all of which are from the balance sheet. They are accounts receivable, inventory, accounts payable and fixed assets.

By looking at these numbers, we notice that all of them are represented in percentages. These percentages are calculated by common size analysis, aka. structure analysis. Basically what common size analysis does is to help calculate the percentage each asset item occupies relative to the total assets. 

Accounts Receivable and Inventory

First of all, let’s look at the accounts receivable and inventory. The accounts receivable of the paper manufacturing company takes up 14% of its total assets. Inventory takes another 7%. For the TV manufacturing company, Its accounts receivable is 23% of total assets, while its inventory takes up 39% of total assets. The combination of accounts receivable and inventory of the paper manufacturing company is 21%, while that of the TV manufacturing company is 62%.

Why does the TV manufactory company have so many accounts receivable and inventory?

Well, on one hand, the competition in the industry is really intense. With so many companies competing for businesses from just a few buyers, these buyers have accumulated immense bargaining power. The buyers not only are able to press down prices, but they also require longer payment time. As a result, TV manufaturers' gross profit ratio decrease and their accounts receivables increase, and our TV manufacturer is no exception. And because competition is really intense, the inventory holding period is longer. This is the reason why the company has such a high level of accounts receivable and inventory.

Generally speaking, companies don’t like accounts receivable and inventory, because they take up our cash positions. Having too much accounts receivable is like loaning money to the buyers for free. On the other hand, companies love accounts payables, for the reason that they can use other people’s cash for free with paying interest. 

Accounts Payable

But in the same industry, will larger sized companies or smaller sized companies more likely obtain more credits, i.e. taking up other companies' cash for free? The answer is obvious - it must be the larger sized company. Large companies, because of their competitive positions in the value chain, can often command credits from both buyers and suppliers alike.

The paper manufacturing company we chose is the largest company in the industry at that time. The TV manufacturing company we chose is not a small company at all, but it is far from being the largest company in its industry. However, from the table above, we see that even the largest paper manufacturing company can only command 8% of cash from its supplier. Yet a relatively less dominant player in the household appliance industry can somehow command 15% cash from its suppliers. Why is this happening?

As we've covered in the previous episode, the Chinese paper manufacturing industry is short on raw materials. A lot of raw materials such as wood pulp must be imported. As a result, these companies, including the largest in the industry, lack bargaining power against their suppliers. In other words, suppliers are in a stronger position.

On one hand, the stronger position gives suppliers the ability to increase the price, and on the other hand, it impacts accounts payable. Suppliers are less willing to extend credits to paper manufacturers when they purchase raw materials. In the household appliance industry, however, we haven't witnessed similar bargaining power from suppliers.

Fixed Assets

For the paper manufacturing company, 62% of total assets are fixed assets. For the TV manufacturer, however, only 14% are fixed assets. Even though both companies are in asset-heavy industries, the level of fixed asset investment is still vastly different.

What is the reason for such a big difference?

The paper manufacturing industry is a capital intensive industry. For every 10,000 tons of paper manufactured, it requires 14 million dollars of investment, which is mainly spent on equipment. This is why a large proportion of assets are fixed assets. 

Total Asset Turnover Ratio

At a high percentage level of 62%, the paper manufacturing company’s assets are mainly fixed assets. The TV manufacturing company's largest asset category, on the other hand, is current asset; when we combine accounts receivable and inventory, we get the total percentage of current asset for the TV manufacturer at 62%. Of these two companies, which one do you think have a faster asset turnover?

Apparently, it should be the TV manufacturer, since current assets have faster turnover than fixed assets. In other words, we'd expect that the asset turnover ratio of the TV manufacturer to be much higher than that of the paper manufacturer. But if we look at the two companies’ actual asset turnover ratios, we will find that the differences are not so significant. 

What’s the reason that the household appliance company didn’t show higher assets turnover ratio like what we've expected?

A likely reason is that the current assets of the household appliance manufacturer have similar asset turnover ratio as the fixed assets of the paper manufacturing industry. In other words, the turnover of its current assets - accounts receivable and inventory - is really slow. 

This could mean its accounts receivable may not be collected for a long period of time. Its inventory may not be sold for a long time, and just stays in the warehouses.

This could be bad news for the TV manufacturer. Since TVs are products that update really fast, the value of the inventory could easily depreciate. On the other hand, if its accounts receivable cannot be collected for a really long time, it’s quite possible that it may become a bad debt.

Another look

Now let’s go back and take another look.

The six financial numbers and their respective ratios clearly describe the industry characteristic of the two industries. 

Gross profit rate reflects the competitiveness of the industries.

Accounts receivable and inventory reflect the bargaining power between the companies and their downstream partners, i.e. the buyers.

Accounts payable reflects the bargaining power between the companies and their upstream partners, i.e. the suppliers.

The proportion of fixed assets reflects the demand on cash of the industry.

And last but not least, asset turnover ratio helps us get a basic understanding of how companies are managed. 

We can see that financial data is a really efficient language. With just some simple financial data, we can clearly have a birds-eye view on an industry’s condition. We can also see how any company in a certain industry sort of carries characteristics of that industry. The financial statements will inevitably reflect such traits. 

---

What we see now is just a static situation. However, industries are changing all the time, and the internal and external environments of industries vary dramatically across different timeframes. How are these changes reflected on companies' financial statements in different industries? We will further explore in the next several episodes. Stay tuned.