Application of Time Series Analysis: A Paper Manufacturer

We've already compared a paper manufacturing company and a TV manufacturing company under a static situation and saw how an industry’s overall situation affects individual company’s financials in the industry.

But industries are not static; they can undergo drastic changes in a relatively short period of time. How will the companies change with the changes of industries? Let’s look at the paper manufacturing company.

Here we list the financial data of three fixed time points - 1998, 2002, and 2012.

1998 is when the paper manufacturing company just started its business. In other words, it is the earliest financial data we can obtain. 2002 is the time we used for our previous comparison with the TV manufacturing company. In 2012, the paper manufacturer has been around 14 years into business. 

First, let’s compare 1998 and 2002.

1998 to 2002

Gross Profit Ratio

Let’s look at gross profit ratios first.

In 1998, the gross profit ratio of the paper manufacturer was 32%; however, it decreased to 28% in four years by 2002. 

What does this mean?

The overall competitiveness of the paper industry has probably intensified over the years, from 1998 to 2002. Gross profit ratio reflects an industry’s competitiveness. The more fierce the competition, the lower the profit margins. 

This is consistent with what we saw earlier about the overall development of this industry. In the past 60 years of the industry, the growth rate of investments never stopped increasing. As more and more investment got into the paper industry, the supply side grew significantly, leading to increased competition. On the other hand, demand has been increasing as well, and that was the reason that the gross profit ratio has only decreased by merely 4%, from 32% to 28%. Nonetheless, the decrease of the gross profit ratio does prove that competition began to emerge in the paper manufacturing industry.

Accounts Receivable and Inventory

As an industry becomes more and more competitive, products will not sell as fast as before. The outcome, more often than not, is the increase of inventory. Let’s take a look at the inventory of the company from 1998 to 2002.

What we see is a decrease, not increase, of inventory from 13% to 7%. At the same time, the company's accounts receivable increased from 10% of total assets to 14%. This is not what we've expected.

When a company is facing more and more competition, what can it do to mitigate competition?

The decrease in gross profit ratio reflects a drop in prices. On the other hand, it seems that the paper manufacturing company made the decision to sell more on credit. Granting buyers more accounts receivables could sell products at a faster pace, as evidenced by the decrease of the company's inventory level. Simultaneously, the drop in inventory coincides with an uptick in accounts receivable level. 

The adoption of agressive credit sales policy is a common practice in competitive markets. For every company, this may be the first strategy companies come up with when they face intense competitions. From a financial perspective, the strategy is actually one that transfers inventory into accounts receivable.

Is this a good thing or bad thing?

Some may think since this strategy helps sell products faster, it should be a good thing. If we can sell our products, we can benefit in many ways. For example, we can grab more market share fairly early. If the products’ market price would decrease in the future, I would have already sold my products.

There is also another direct benefit: Since inventory usually needs warehouses for storage, selling products at a faster pace would save us warehouse costs.

Now that I have sold my products, my inventory becomes accounts receivable, which is closer to becoming cash. Therefore, the overall turnover is also accerlerated.

All of the above are benefits of turning inventory into accounts receivable as fast as possible. However, doing so can also cause some potential problems.

Let's say if I have sold the inventory, will all the accounts receivable be collectable? There is always risk that some of the accounts receivable will become bad debt. And once accounts receivable becomes bad debt, none of the above benefits will matter: my inventory can be sold for some money regardless of the prices, but my accounts receivable will go down to 0 if it becomes bad debt. It's essentially the same as having the warehouse looted. 

Now that we've seen both these aspects, whether it's a good or bad thing to turn inventory into accounts receivable is really contingent on whether accounts receivable can be collected. If we can collect the money, obviously turning inventory into accounts receivables will help the product’s sales. But if accounts receivable is not collectable, all benefits we've mentioned will be worth nothing.

2002 to 2012

Now let’s take a look at what happened from 2002 to 2012.

Gross Profit Ratio

In 2002, the gross profit ratio was 28%, but it decreased to 15% in 2012. Why was there such a drastic decrease?

Let’s recall what we discussed before about the competitive structure of the paper manufacturing industry. The year of 2008 was a watershed for the paper manufacturing industry, when the Chinese paper manufacturing industry entered the phase of excess capacity. In other words, after 2008 the competition within the industry became significantly more fierce than before. And because of this fierce competitive environment, the gross profit ratio of the paper manufacturing companies dropped significantly.

Accounts Receivable and Inventory

Let’s take a look at the accounts receivable and inventory.

From 2002 to 2012, the accounts receivable dropped from 14% of the company's total assets to 8%. Inventory, on the other hand, increased from 7% of total assets to 9%. Why didn’t we see the same trend from 1998 to 2002, the trend that inventory decreased and accounts receivable increased?

The aggressive credit sales strategy that the paper manufacturer employed from 1998 to 2002 is a natural response when companies face fierce competitions. However, by adopting this strategy, companies would have to face the obstacle that some accounts receivable will never be collected. Overall, the credit sales policy is rather a temporary solution than a permanent solution.

As more and more companies adopt the same credit sales policies, the playing field is gradually leveled again, giving no particular company an advantage. At this point, adopting the credit sales policy is rather a passive method than a proactive method, eating out everybody's profits along the way. And competition is much more fierce than ever. 

Once the phenomenon of granting credit sales to buyers becomes passive, more credit sales won’t necessarily decrease inventory anymore; but it definitely increases the company's financial risks. The paper manufacturer, which realized this, stopped granting credits recklessly in an attempt to move inventory out. Instead, it switched to a more balanced strategy as a way to mitigate risks.

These are the financial situations of the paper manufactory company across different development stages in dozens of years.