Now let’s discuss how to calculate the cost of invested capital.
Just now we discussed who the investors are, i.e. people that would put money into the company. They are creditors of interest-bearing liabilities and shareholders.
When I borrow money from creditors, would there be any costs? Apparently so.
But what is the cost? When I borrow money from, say, the bank, there will be interest rates that I will have to bear. That will be my cost of using money from creditors.
But what about shareholder’s money? Does it have costs?
We know that if we use shareholder’s money, we don’t need to pay interests. However, we do need to pay dividends to shareholders. However, dividend payment is voluntary, and no company is forced to give out dividends. In other words, unlike paying back banks with principals and interests, which is protected by laws, a company that doesn’t pay dividends won’t get punished by the law.
For instance, Berkshire Hathaway, the company led by the world-famous investor Warren Buffett, is famously known to not pay any cash dividends to its shareholders in the history of the company’s existence. However, this hasn’t stopped investors from pumping money into the money and snatching up the company’s stocks, pushing its share prices higher and higher. This just shows that a company can use shareholders’ money without paying dividends.
Therefore, this means that using shareholder’s money will have zero cost right?
Wrong. Big time.
When a shareholder invests in a company, she automatically loses the opportunity to use the same capital to invest in any other company in the world. What this statement describes is the concept of opportunity cost; the money that a shareholder could have earned by investing in another company represents the cost when he chooses this company.That’s why we call it opportunity cost. Whenever a shareholder invests in one company, he bears such an opportunity cost because he bears the cost of giving up another opportunity.
So what does a shareholder want? He wants to gain return higher than cost. To put it another way, his return is the return of the invested company. His cost is the opportunity cost, which is the return that he could get if he invested in another company. So when he requires returns higher than the cost, it means he hopes this company can generate returns higher than other companies.
This is a fairly simple idea. For example, let’s assume that one year ago, there were three investment opportunities in front of me. I chose one of them, automatically giving up on the other two. After one year, I wanted to compare how much I could have earned if I invested in the other two companies. Only when the company I invested in earned the highest returns among the three could I be satisfied. Otherwise, even if this company makes money but less than the other two, I will still regret my decision, because I gave up investing in better opportunities.
Now that we’ve understood that the cost to shareholders is opportunity cost; however, since paying dividends is not protected by the law, I can simply ignore them. Can it be done this way?
Well in a market economy, there will be repercussions. Why?
As the manager of a company, who hires him? Shareholders. If he can’t give shareholders the required returns, shareholders can change the management with new ones. Even though the shareholder may not be that influential because he is not holding enough stocks, lacking the power to change management of the company, he can vote in other ways. He can withdraw all his holdings from the company to protect himself. If it happens on a massive scale, i.e. when lots of investors sell a company’s stocks in a short period of time, the stock price will drop, eventually causing the dismissal of the management anyway. Such a company can’t survive in the market. That’s why in a market economy, if shareholders ask for returns, the company must provide.
How much return do shareholders normally ask for?
We know that an investor’s cost is the opportunity cost that he loses in investing in other companies. But which other companies?
The companies should have similar risks to the company we’ve invested in. For example, some businesses involved in illegal activities are inherently more lucrative and risky at the same time, and their returns shouldn’t be taken as our opportunity costs. Normally we’d choose companies from the same industry since they share similar risk levels. These companies may make more money or less, and we will use the average return of the industry as our standard of the opportunity cost.
There are two ways to measure the average return of an industry. One is to use the average return on investment in the stock market of that industry to find out the cost. Another way is to calculate the average profitability of the companies in that industry. Here we will use the latter method.
Assuming that we have calculated the cost of capital from creditors and that from shareholders, the next step is to find out the cost of invested capital. A common way of calculation is the weighted average method. For example, let’s assume that 40% of my funds come from creditors with an interest rate of 7%, and 60% come from shareholders. Assuming that the average profitability of the industry is 12%, then we know the cost of invested capital should be calculated as 40% × 7% + 60% × 12% = 10%. The cost of invested capital calculated by the weighted average method is called weighted average cost of capital, or WACC. WACC is the standard of measuring whether a company generates a positive or negative return.
However, there is a minor mistake in the calculation of WACC. Let’s look at an example.
Assuming there are two companies and their EBITs are completely the same, say 100 dollars. Recall that EBIT refers to the profit before interests and income taxes. How do we get the profit? You may remember that the company gets the net profit after paying interests and taxes, so if we add taxes and interests to the net profit, we will get EBIT or earnings before interests and taxes.
We assume the EBIT of the two companies are the same, and their income tax rates are both 25%. The only difference is that one company borrows money from the bank, while the other one has no loans. For the company having no bank loans, its EBIT is 100 without interest expense. Then we deduct the income tax, or 25% of EBIT, resulting in 75 dollars of net profit.
Now let’s look at the other company with interests. The company has an EBIT of 100, but it needs to pay the bank 20 for interest. After paying the interest, the profit of the company becomes 80 dollars. The company then pays 25% of the 80 dollars as income tax, resulting in a net profit of 60 dollars.
If we compare these two companies, we will discover that the second company pays 20 dollars more than the first company for interest, but its profit is only 15 dollars less. Where is the other five dollars?
The reason is simple. The income tax of the second company is actually 5 dollars less than that of the first company. Even though it needs to pay 20 dollars worth of interest to the bank, 5 out the 20 dollars are actually “paid” by the government.
This sounds like too good to be true; however, it actually is the case. Since the company pays income tax after interest, the more interest it pays, the less the EBIT the company has, and the less income tax it has to pay to the tax bureau. We call this effect the tax shield of interest. Due to this effect, we now know that although a company pays 20 dollars of interest to the banks, it only bears 15 dollars by itself, or 75%. In this sense, if the interest rate of a bank loan is 7%, now we know the cost we bear is not exactly 7%, but 7% × (1-tax rate). If the tax rate is 25%, out de facto interest rate will be 7% × 75%, or around 5%. This is how we calculate WACC.
Sharing my learnings about the core skills on how to run life like a company in the Me Inc. Newsletter. Topics covered: Copywriting, Finance, Technology, and Productivity. Read my why here or join directly👇. No spams. Ever. – Michael
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We’ve covered how to calculate return on invested capital in our previous episode. The rates of return on invested capital of this company in 2008, 2009, and 2010 were 10%, 5%, and 6.6% respectively. Given such figures, do you think the company is making money? To be more specific, do you think such a rate of return on invested capital is acceptable?
What we often hear is that the return on invested capital should at least be on par with loan interest rates, inflation rates, expected return of investors, or industry standards.
However, all of the above rates can be very much different from each other. Loan interests might be much lower than the average profitability rate in the industry; inflation rates could be quite different the expected return of investors. Is there any fixed benchmark for the rate of return on invested capital?
Let’s analyze this question.
At the end of the day, what the return on invested capital measures is still a type of return on investment. From the simplest sense, what any investor wants is at least not to lose money, i.e. the return should be higher than the cost. Therefore, one type of benchmark for evaluation is the cost of investment from investors. In other words, it is the cost of invested capital.
Let’s assume we have calculated the cost of invested capital (we will get to the calculation of this number in the next episode) for the company in each year from 2008 to 2010, which are 5.7%, 7.6%, and 7.6% respectively.
Now that we have both the return on the invested capital and cost of invested capital, we can simply let the former minus the latter and see if the result is positve or negative. The result is often referred to as excess return.If the excess return is positive, we’d say such investment is acceptable, and if it is negative, we’d say it is unacceptable.
From our calculations, we can see that only 2008 yielded a positive excess return. Both year 2009 and 2010 yielded negative excess returns. And since we already know the invested capital for each of the three years, we can get each year’s economic profit by multiplying excess return and invested capital for that particular year.
Apparently, the economic profit was only positive for the first year and negative for the rest two years. In other words, the return on investment of the company is only acceptable in 2008, not in 2009 and 2010.
This conclusion might come as extremely shocking to a lot of folks, including me. After all, the company has made billions of net profit each year at an annual average growth rate of 26%. How could a profitable and growing company be a bad investment?
The answer lies in cost; like anything in this world, growth and profitability also have prices. And if their prices (or costs) exceed the value of the growth and profitability, the investor could be better off putting her money somewhere else.
Next, we will cover how to calculate the cost of invested capital.
Sharing my learnings about the core skills on how to run life like a company in the Me Inc. Newsletter. Topics covered: Copywriting, Finance, Technology, and Productivity. Read my why here or join directly👇. No spams. Ever. – Michael
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Previously we’ve covered some factors that affect financials of businesses. Broadly speaking, there are three factors:
Industry situation such as competitiveness
The company’s strategic positioning
The company’s execution on its strategy
To truly understand a company, it is crucial to know what our ultimate goal is in creating and operating a business.
From the outside looking in, we want to know if a company is good or bad. However, how do you define “good”? Everyone may have their own opinions. You may think a good company should have growth potentials. Some may think a good company should have good leadership. And some others may think a good company should have a good team. Despite all of the above being true, a good company should at all times have the capability of running sustained business, i.e. being able to create adequate cash flow. In other words, we want all of the above things to be true: we want the company to be led by a good entrepreneur, have good teams, foster good corporate culture, or stay competitive in the market. But our ultimate goal is to make money.
The bottomline of a good company is that it can make money. But what is making money?
The first off the top of your head should be the income statement. From the statement, we can tell how much revenue the company generates, and how much profit it makes. We can easily draw a conclusion of whether the company is profitable or not.
Some people may say just income statement is not enough, and we should look at the statement of cash flow as well. So what does making money really mean?
Let’s use an example.
During the three years in this company’s operations from 2008 to 2010, it has generated 10.1 billion CNY, 13.8 billion CNY and 18.5 billion CNY of revenues respectively. The annual average growth rate of the company’s revenues from 2008 to 2010 is about 35%. This growth rate at the scale of the business is quite remarkable.
The profits of the respective years are 1.7 billion CNY, 1.8 billion CNY and 2.7 billion CNY respectively, with an annual average growth rate at about 26%.
From either the perspective of revenue or profit, the company’s financial performances, especially its growth rate, is really fast.
With both the company’s net profits and revenues at hand, we can easily calculate the net profit ratio of the company in each year. Recall that the formula to calculate net profit ratio is as such:
Net Profit Ratio = Net Profit / Revenue
Take the year 2008 as an example. In 2008, the net profit was 1.7 billion, and its sales revenue was 10.1 billion, resulting in a net profit ratio of 17%.
How would you judge a company that generates 10.1 billion in revenue, 1.7 billion in net profit, and has a net profit ratio of 17%? Pretty impressive right?
Can this company be regarded as making money?
If we recall, when we measure the profitability, apart from the net profit rate which concerns returns, we have also discussed another topic called return on investment. We’ve gone through what level of return this company generates throughout the years, but we still don’t know how much was invested in. Now let’s look at what the return on investment looks like.
Return on Invested Capital
Here we will introduce a new concept that helps describe the return on investment called return on invested capital, which is the result of net profit divided by invested capital. I also want to put a caveat here on “net profit” as it is not the same as what we have discussed before, but will circle back to see how exactly we can calculate this later in this episode. For now, let’s just take a look at the formula of how to calculate return on invested capital:
ROA and ROE
You may still remember that in our previous episodes, we have introduced two financial data describing return on investment, which are return on total asset and return on equity.
Return on total asset (ROA) is the result of net profit divided by the total asset. We have learnt that the total asset includes liabilities and shareholders’ equities, meaning that return on total asset actually describes the level of return that the company generates from the perspective of creditors and shareholders.
Return on equity (ROE), on the other hand, only concerns the level of return from the perspective of shareholders; it is calculated by dividing net profit by shareholders’ equities.
You may be wondering why we still need a new indicator to calculate a company’s returns, considering that we already have ROA and ROE. Is there any relation between the new indicator, return on invested capital, and the old ones?
We have briefly mentioned that the return on invested capital is the result of net profit divided by invested capital. First, let’s look at the denominator, invested capital.
Invested Capital
Let’s explore who are the investors in a company. Here we will define investors in a broader sense.
The first party coming to our mind would be shareholders. They put their own money up to create a company, and in exchange, they got shares or ownership.
However in fact, we know creditors also invest in companies. Take banks as an example. Why do banks lend money to a company? The purpose is to gain returns through loans. Banks not only get their principals back, but also interests on those loans as well. Therefore, it is also a type of investment into the company.
Understanding this, let’s visit some other liability items on the balance sheet. We know that on the balance sheet, bank loans are just one type of liability. There are still other types of liabilities. The company might also owe money to suppliers, which are called accounts payable. It might owe money from the employees, which is called wage payable. It might also owe money from clients, which is called deposit received or prepaid accounts. It might also owe money from tax bureaus, which is called tax payable.
Though all of the above are all liabilities just like bank loans, we can’t say that our clients, suppliers, employees and tax bureau are our investors, for the reason that they don’t lend us money to gain returns. Therefore, only liabilities that bear interests qualify as invested capital.
By now we are ready to conclude on how to calculate invested capital. Invested capital is the total of interest-bearing liabilities and shareholders’ equity.
As a result, we can see invested capital is smaller than total assets.
Net Operating Profit After Tax
I’ve mentioned that there is a caveat when we talked about how return on invested capital is net profit divided by invested capital. Now let’s look at the numerator – the “net profit” we’ve talked briefly at the beginning.
Instead of using net profit, we should use the net operating profit after tax. Let me tell you why.
If we take net profit, the result will be net profit divided by invested capital. We’ve already covered that invested capital is a more accurate definition of the total asset by including only assets targeted to generating returns. The right to distribute net profit belongs to shareholders only. Creditors do NOT have this right.
If we exchange invested capital with total asset, and after-tax net operating profit with net profit, this ratio will become net profit divided by total asset. In other words, it is actually what we have discussed before, return on total asset.
If the denominator – invested capital – represents the total investment of shareholders and creditors, the numerator should represent the total return of shareholders and creditors. We know shareholders will get the net profit of the company, and creditors will get the interests from the loans they provide. Combining both, we will come up with what we call as net operating profit after tax.
Let’s look at the income statement and see how to calculate net operating profit after tax. Normally when we calculate profits from income statement, we will deduct financial expense. Such an expense includes the interests we pay to the banks. We will need to add back the financial expenses to the net profit, together with any non-operating gains/losses if there is any.
Now let’s see how much is the return on the invested capital of this company. Through some basic calculations, we know that the figures are 10%, 5% and 6.6%. However, we still haven’t been able to answer this question: is this a good company? With such a level of return on invested capital, is the company making money?
Sharing my learnings about the core skills on how to run life like a company in the Me Inc. Newsletter. Topics covered: Copywriting, Finance, Technology, and Productivity. Read my why here or join directly👇. No spams. Ever. – Michael
Welcome to the Me Inc. Newsletter.
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Previously we went through how an industry’s changes affect the financial statements of individual companies, including a paper manufacturer and a TV manufacturer. At the beginning of our discussions, we mentioned that any company’s decision making will be affected by the environment it is in, and its own strategic choice. Next we are going to discuss how the strategic choices affect the financials of a company.
Cost Leadership Strategy – Small Profit High Volume
Generally, there are two types of strategic positioning. The first is cost leadership.
What is the cost leadership strategy?
If products of my company are not very different from other products, a very natural way to boost my competitiveness is to lower the costs. I can expand capacity, improve efficiency, or simplify my product design and so on. I will try all kinds of methods to lower my costs.
Once my costs are reduced, i will be in a better position to lower prices, making my products more attractive to customers. In our daily life,
there is a saying describing the cost leadership strategy, which is small profit high volume. This saying perfectly sums up the cost leaderhip strategy.
However, when we say a company employs a “small profit high volume” strategy, what is the profit that we are referring to? Is it gross profit or net profit?
Well, we already know that the reason such company has a small profit is that it purposefully sets the prices low. When it does, a direct result from such as strategy is a relatively lower gross profit ratio. From gross profit to net profit, there might be some expenses subtracted, and some income added. These expense/income items are not only the results from strategy choices, but also managerial performances. In other words, the “profit” in small profit high volume strategy refers to gross profit.
Now lets look at “high volume”. Does “high volume” equal to high revenue?
If you think about it, it is quite difficult to judge what qualifies as high revenue. The number is drastically different for different companies in different industries. From the literally sense, “high volume” is selling more products. However, we should always set a limit to such claims such as timeframe. In other words, “high volume” should mean selling more products faster than others; so “high volume” actually means rapid sales.
How is high volume represented on financial reports?
Based on the descriptions above, we got the feeling that a faster sales is better efficiency, or faster turnovers. So “high volume” actually means high turnovers for the company.
By now we have known that the normal expression of a cost leadership strategy is “small profit high volume”, and the financial expression of it is “low gross profit rapid turnover”. Because the company has low gross profit, it has a low effectiveness. To make up for the low effectiveness, it needs a high efficiency. The cost leadership strategy is a strategy that sacrifices some effectiveness to pursue high efficiency. The cost leadership strategy is winning by efficiency.
Differentiation Strategy – Big Profit Small Volume
Contrary to the cost leadership strategy, differentiation strategy is a strategy that improves product features to differentiate it from other competitors. For example, my company may have the broadest range of products; or my service is well-known in the industry, well above that of other companies; or my deliveries are flexible and on time, etc. This is what we call a differentiation strategy.
In any industry, we can always witness that some companies choose the cost leadership strategy, and some other companies choose the differentiation strategy.
For example, in the retail industry, we can find small convenience stores and large fancy shopping malls. The malls will have better decorations, more comfortable shoppingenvironments, and better services, all contributing to more expensive products sold at the malls. The convenience store, on the other hand, may be located in a rather remote location, provide limited services, but have lower prices for the same products.
For companies that employ differentiation strategies, the gross profit ratios are normally higher from the higher prices. However, there won’t be too much demand for high-end products, generally speaking. So naturally its turnover rate will be lower.
On financial reports, a company that employs differentiation strategy will show high gross profit ratio and low turnover. Because of the high gross profit ratio, its effectiveness is great, but because its turnover is lower, its efficiency is relatively slow. Therefore, we say differentiation is a strategy that sacrifices efficiency in exchange for effectiveness.
A company normally pursues premium pricing as part of its differentiation strategy. The company already knows its demand will not be as big as the low-end market; however, this is its own choice. We call the differentiation strategy winning by effectiveness.
From the above discussions, we see that different strategies bring different financial performances. However, their goals are the same – to create return on investment. It is the process of creating the desired ROIs that’s different. Some companies choose to win by efficiency, while others by effectiveness.
Paper Manufacturing Industry
Let’s use the example of the paper manufacturing industry to illustrate how strategy is selected.
In the paper manufacturing industry, there are a lot of companies adopting the cost leadership strategy. The reason is simple; even a very experienced professional may have a hard time guessing which company produced a specific piece of paper. The final products – paper – are very hard to differentiate. In addition, the paper manufacturing industry is capital-intensive. It requires huge amounts of investments for equipment. To make matters worse, almost every kind of paper needs a different piece of equipment, requiring even more investments if the company wants to expand the product line.
Knowing this, it is not difficult to understand that the major costs of paper productions are fixed costs. Regardless of the actual output, fixed assets will have already been purchased. Therefore, the more paper the company products, the lower the per unit fixed cost will be. This is called economy of scale: if an industry requires siginificant levels of investments, only companies with large enough production outputs can break even by achieving economy of scale. This is why most paper manufacturing companies will choose the cost leadership strategy.
However, it is still possible that some paper manufacturers choose the differentiation strategy.
For example, a company may improve its paper quality and focus on a niche market to achieve differentiation. Here we are going to choose two paper manufacturing companies to illustrate the two strategies.
The first company only produces a particular kind of cigarette paper. The market demand for cigarette paper is really small, but the paper has a relatively high level of profits. The company adopted a differentiation strategy that focuses on making high profit products for only one segment.
The other company produces paper for newspapers. This company is really big, using a cost leadership strategy.
We will find that the company adopting the differentiation strategic position will have higher gross profit rates but lower turnover. By contrast, the company adopting the cost leadership strategy will have lower gross profit rates but higher turnover.
This verified one of our earlier analyses.
However, we may not always find the desired results.
Sometime we will find companies using the cost leadership strategy with low gross profit ratio AND low turnover, or companies using the differentiation srtrategy with low turnover AND a not-so-high gross profit ratio.
What might have gone wrong then?
Well, our definition of a strategy is that a company gives up one goal to pursue another goal tactically. However, if the execution of a strategy goes wrong, the company may find that even though it purposefully gives up one thing, it may not necessarily achieve the other. In other words, it may find a decreasing efficiency and effectiveness at the same time, and when it does, we can normally conclude that something has gone wrong with its execution on strategies.
The financials of a company not only bears the mark of its industry, but also show the company’s strategic positioning. In addition, they also show how the strategies are executed by the company.
Sharing my learnings about the core skills on how to run life like a company in the Me Inc. Newsletter. Topics covered: Copywriting, Finance, Technology, and Productivity. Read my why here or join directly👇. No spams. Ever. – Michael
Welcome to the Me Inc. Newsletter.
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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.
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