Application of Time Series Analysis: A TV Manufacturer
In the previous episode, we examined the time series analysis of the paper manufacturing company. Along with the development of the industry in the past dozen years, the financial data of the company also changed. Next let’s take a look at what the trend is for the household appliance manufacturer.
Here we list the TV manufacturer's financial data in 1996, 2002, and 2012.
1996 to 2002
Gross profit ratio - a signal of industry-wise competition level
In 1996, the company’s gross profit ratio was 27%. In 2002, the gross profit ratio dropped to 15%, a schockingly high rate of decrease in merely six years.
This drop in gross profit ratio is actually consistent with the competitive environment of the industry. The house appliance industry entered intense competition in a short period of time, causing gross profit ratios of all companies in the industry to decrease significantly. The reason of such drop is simple: as prices in the market got lower and lower, certain costs remained stable, leading to a lower gross profit ratio.
The decrease of gross profit rate shows that the TV company is losing the ability to demand high market price. When this happens to the majority of industry participants, we say that the market environment has become bad.
Could management be the solution to the drop in gross profit ratio?
When the market environment becomes bad, we may need to rely on management methods.
How can we use management methods to mitigate the impact from the intensified competition?
Let’s recall a crucial formula we covered in previous episodes: net profit ratio x total asset turnover = return on total asset.
A company’s return on investment is determined by efficiency and effectiveness. From the formula above, we know that there are two ways to improve the return on investment (total asset). One way is to improve the effectiveness, the other is to improve the efficiency.
Generally speaking, if a company’s gross profit ratio decreases, there is no way that its net profit ratio will increase. In other words, with the decrease of gross profit ratio, the effectiveness of the company will fall.
What do we mean by mitigating the impact of the market through management methods?
There are two approaches. The first approach is to reduce costs and expenses in order to reduce the impact to the decreased net profit ratio. But even so, the room for cost/expense reductions are very limited.
The other is to improve efficiency. In other words, when effectiveness becomes worse and worse, we need to improve total asset turnover to maintain return on investment.
However, efficiency of the TV manufacturer - the total asset turnover ratio - decreased instead.
This seems a little weird.
What might be the reason for the decrease of the turnover ratio? Does the company ignore the pressure of the market? Let's think about it.
For companies in the household appliance industry, a big part of assets will be fixed assets, including equipment and plants, etc. Additionally, as competition in the industry gets worse, accounts receivable and inventory suddenly increase.
As competition forces the company to accept more accounts receivable, and as the market becomes more and more crowded, rendering products harder to sell, both accounts receivable turnover and inventory turnover deteriorates. On the other hand, competition requires the company to accept more sales on credit to satisfy its customers’ needs, and the collection period of accounts receivable becomes longer. And more and more products in the warehouse, i.e. inventory, will stay there for quite a long time before they can be sold.
Another result of intensified competition is excess capacity.
Excess capacity means a surplus of supply compared to demand. When excess capacity happens, how will the financial data of the company be impacted?
Which item reflect capacity in the financial reports? Someone may say it’s inventory. But as we know, inventory is not really capacity. Inventory is the result of such excess capacity. Capacity is the ability to produce - if there is too much equipment, too much land, too many labor forces, etc., there is excess capacity. For example, if all equipment are running at full capacity, they will produce too many products, much more than the actual demand. In situations like this, companies will normally let some of their equipment idle. These are called idle fixed assets. Once this happens, part of the fixed assets are not creating value.
Let's circle back to a concept called fixed assets turnover. Fixed assets turnover is calculated by dividing revenue by fixed assets. If part of fixed assets are not creating any revenue but still remain on the balance sheet, the whole fixed assets turnover will decrease.
For the TV manufacturer, it is evident that most of its important asset turnover ratios, including those of accounts receivable, inventory, and fixed assets, are deteriorating from 1996 to 2002, leading to a much worse total asset turnover ratio.
Drops in both efficiency and effectiveness will lead to drop in ROI
Although the company has put a lot of effort into improving management, it still can’t fight the trend of the industry. That’s why we don’t see an increase in total asset turnover ratio. As the effectiveness and efficiency of the company drop, its return on investment will drop significantly as a result.
From 1996 to 2002, we saw a very different trend happening compared to the paper manufacturer. As competition intensified, the paper manufacturer's accounts receivable increased and inventory decreased. However, we can see that for the household appliance company, both its accounts receivable and inventory increased significantly.
Why isn’t it the same as the paper manufacturer with one increasing and the other decreasing?
When the accounts receivable and the inventory move in opposite directions, it means that the sale of inventory is really sensitive to the accounts receivable policy. When the paper company increases credit sales, the inventory will be sold much faster. If I reduce credit sales, the inventory will move slower. What this means that the credit sales policy can still make a positive impact in the market, leaving different companies some room to maneuver.
On the contrary, when the accounts receivable and inventory are moving in a same direction, it means even if the company grants more credit sales, products are still not sold. The competition is so intense that whatever the company does, either proactively or passively, nothing is happening. The only result is the increased accounts receivable and inventory taking up a huge portion of the company's cash.
2002 to 2012
From 2002 to 2012, we can see that the gross profit ratio hardly changed, growing only from 15% to 16%. The competition in the TV industry was basically stable during these ten years.
Under the competitive market dynamics, we see that the total asset turnover ratio has improved from 0.69 to 0.96, and both the accounts receivable and inventory decreased, signaling an exciting positive trend. The number seems to indicate that the company improved its management by a large amount.
Unfortunately, the actual reason of how the turnover ratios increased is not what we expected.
Shortly after 2002, the company started expanding internationally, and all its international business was conducted via a third-party company. Unfortunately, this company went into full-blown financial crisis and eventually a bankruptcy, leading to the TV company having to write off all accounts receivables owed by the third-party company as bad debt. As a matter of fact, the TV manufacturer wrote off 3.1 billion USD as bad debt once. The consequence of this is that the company's accounts receivable dropped significantly, but it also had to report losses for several years afterwards.
Additionally, the TV manufacturer, in order to decrease its accounts receivable and inventory levels, sold part of its accounts receivable and inventory to a related company. In other words, their decrease in account receivable and inventory is not through normal operations. Even though on paper, all ratios seemingly have improved throughout the years, such improvement does not reflect an improved business opeations of the company. In fact, the company actually is getting worse, amounting huge sums of losses along the way.
