Overview
Analyzing Cross Statement Relationships: Revenue, Cost of Revenue and Cash Cycles
The above analysis has controlled for seasonality by working with the December 26, 2010 Balance Sheet Information. In addition, the Amended columns work with the amended revenue and COGS numbers to compare against the numbers pulled directly from the filings.
In the previous
Valuation Tutor lessons, you have largely considered each statement in
isolation of each other. This type of
analysis is required to gain the important insights that can be extracted for
each statement. In this lesson you will
learn how to work across statements to evaluate a firm’s operating activities
using the visual analytic tools provided by Valuation Tutor. These tools allow you to “connect the dots”
visually and then drill down to better understand how management is currently
performing.
First, you can literally
extract different pieces of information from different financial statements
using the “Data Collector” tab and then apply the visual tools to tease out
relationships. For example, suppose you
want to focus closely upon a firm’s operating activities. For this case you would like to examine Sales,
Deferred Revenues, Cost of Sales, Gross Margin, Accounts Receivable, Inventory
and Accounts Payable and then observe how these accounts are interrelated
across the statements. We illustrate
this approach for 1-800-Flowers next.
Collect the data fields
first by first selecting the Statement in the Left Hand Side (LHS) below, and
clicking on the “Data Collector” tab in the right hand side (RHS). To automatically transfer the data just
double click on the desired field names (e.g., Net Revenue in the LHS below).
Note: 1-800-Flowers do
not have any Deferred Revenues.
Select Pie Chart
(checked box above in the RHS of the screen).
Operating activities can
be further broken up into three subsets of activities: revenue related activities (i.e., revenue
cycle), cost of revenue related activities (i.e., cost of revenue cycle) and
the cash conversion cycle.
Revenue Related Activities
US GAAP has expended
many resources on providing guidance for how to recognize revenue when a sale
is made. Generating revenue may be
relatively straightforward for a typical retailer such as a Wal-Mart sale, that
is either for cash or on account or card.
Revenue for a technology firm, however, is often complicated by the fact
that a sale can involve a contract that specifies a bundled set of goods and
services that unfold over time. In this
case the sale cannot be viewed as entirely revenue because some of this revenue
has yet to be earned. As a result, part
is processed as deferred revenue until earned by performing the services or
delivering the good.
For revenue earned there
are two general models that accounting applies.
First, is the merchant model
of revenue recognition that allows gross
revenue to be recognition. This is appropriate
for a Wal-Mart, who assumes the risk of carrying inventory, return policies
etc.,. It is not appropriate for a “Ticketmaster”
type of business model who acts as an agent on behalf of the ultimate service provider.
In this case revenue must reported on a net as opposed to a gross basis and this is referred to as the agent model. To make matters
more confusing, many companies apply a combination of merchant and agent models
when recognizing their revenues because each model may be appropriate for a
subset of their goods and services. That
is both gross and net revenues are aggregated which require that analysts be
alert for any significant changes that slip in for revenue recognition if
disclosed. This is because if a firm shifts
from net to gross revenue reporting this can really boost revenue growth
numbers!
Accounting for Revenue Related Activities:
Dr Cash or Accounts
Receivable
Cr Revenue
Cr Deferred Revenue (Current and/or
non-current)
Dr Deferred Revenue
(non-current)
Cr Deferred Revenue (current)
Dr Deferred Revenue
(current)
Cr Revenue
An analyst is interested
in inferring whether revenue has been primarily driven by the first set of
three entries or whether the latter set has played a role. In addition, if it is the first three entries
has credit been relaxed to help maintain revenues?
The second set of
transactions is defined from the Cost of
Revenue Related Activities:
Dr Cost of Sales and or
Cost of Goods Sold
Cr Inventory or Accounts Payable/Cash
Similarly, under the
matching principle additional entries will be recognized such Marketing costs
that are associated with selling goods and services.
Finally, estimating the Cash Conversion Cycle requires working
with the the major working capital accounts, Accounts Receivable, Accounts
Payable and Inventory. The objective of
the cash conversion cycle is to understand how quickly the firm converts sales
to cash. By considering these three main
working capital accounts, an analyst can first calculate turnover ratios by dividing
them into Sales or Cost of Goods Sold whichever is applicable for each account as
indicated below:
Operating activities can
be further broken up into three subsets of activities: revenue related activities (i.e., revenue
cycle), cost of revenue related activities (i.e., cost of revenue cycle) and
the cash conversion cycle.
Revenue Related Activities
US GAAP has expended
many resources on providing guidance for how to recognize revenue when a sale
is made. Generating revenue may be
relatively straightforward for a typical retailer such as a Wal-Mart sale, that
is either for cash or on account or card.
Revenue for a technology firm, however, is often complicated by the fact
that a sale can involve a contract that specifies a bundled set of goods and
services that unfold over time. In this
case the sale cannot be viewed as entirely revenue because some of this revenue
has yet to be earned. As a result, part
is processed as deferred revenue until earned by performing the services or
delivering the good.
For revenue earned there
are two general models that accounting applies.
First, is the merchant model
of revenue recognition that allows gross
revenue to be recognition. This is appropriate
for a Wal-Mart, who assumes the risk of carrying inventory, return policies
etc.,. It is not appropriate for a “Ticketmaster”
type of business model who acts as an agent on behalf of the ultimate service provider.
In this case revenue must reported on a net as opposed to a gross basis and this is referred to as the agent model. To make matters
more confusing, many companies apply a combination of merchant and agent models
when recognizing their revenues because each model may be appropriate for a
subset of their goods and services. That
is both gross and net revenues are aggregated which require that analysts be
alert for any significant changes that slip in for revenue recognition if
disclosed. This is because if a firm shifts
from net to gross revenue reporting this can really boost revenue growth
numbers!
Accounting for Revenue Related Activities:
Dr Cash or Accounts
Receivable
Cr Revenue
Cr Deferred Revenue (Current and/or
non-current)
Dr Deferred Revenue
(non-current)
Cr Deferred Revenue (current)
Dr Deferred Revenue
(current)
Cr Revenue
An analyst is interested
in inferring whether revenue has been primarily driven by the first set of
three entries or whether the latter set has played a role. In addition, if it is the first three entries
has credit been relaxed to help maintain revenues?
The second set of
transactions is defined from the Cost of
Revenue Related Activities:
Dr Cost of Sales and or
Cost of Goods Sold
Cr Inventory or Accounts Payable/Cash
Similarly, under the
matching principle additional entries will be recognized such Marketing costs
that are associated with selling goods and services.
Finally, estimating the Cash Conversion Cycle requires working
with the the major working capital accounts, Accounts Receivable, Accounts
Payable and Inventory. The objective of
the cash conversion cycle is to understand how quickly the firm converts sales
to cash. By considering these three main
working capital accounts, an analyst can first calculate turnover ratios by dividing
them into Sales or Cost of Goods Sold whichever is applicable for each account as
indicated below:
Accounts
receivable turnover = Sales/Accounts Receivables
Inventory
turnover = COGS/Inventory
Accounts
payable turnover = Purchases/Accounts payable or otherwise COGS/Accounts
Payable
Next, by dividing the turnover
into days in the year converts a turnover ratio into a number that is easily
interpreted. This numbers answers the
questions:
On average how long does it take
to sell inventory, collect accounts or pay accounts?
These are defined as follows if
the above Sales and COGS are annual numbers:
Number
of days to Collect Accounts Receivable = 365/Accounts receivable turnover
Number
of days to Sell Inventory = 365/Inventory turnover
Number
of days to Pay Creditors =365/ Accounts payable turnover
Question:
What happens if we are working from a 10-Q and have numbers for 3-months
or 6-month accounting periods?
Accounting
Stocks and Flows
To answer this question we must
first make a careful distinction between “stocks” and “flows” as applied to
accounting measurements. An accounting
stock is an account balance that is measured at point in time and represents
the closing balance of that account at this point in time. The fundamental accounting equation
represents “permanent or stock accounts” and therefore the balance sheet
measures the financial position at a point in time. Flow variables or “temporary accounts” are
measured over an interval of time, referred to as the accounting period. Sales and COGS are both “flow”
variables. This is why a turnover ratio,
defined relative to Sales or COGS, can be converted into an equivalent
representation in time. However, when
working with the 10-Q we have to be careful to get time correct. That is, if working with 6-month Sales and
COGS then the divisor is 182.5 and if three months 91.25. We will return to this in the 1-800-Flowers
Example below.
Cash
Conversion Cycle
The Cash Conversion cycle is the
aggregate number of days for collecting accounts receivable plus the number of
days required to sell inventory minus
the days to pay creditors.
Cash
Conversion Cycle = Number of Days to Sell Inventory + Number of days to collect
accounts receivables – Number of Days to Pay Payables
Combined an analyst armed with
revenue cycle information, cost of revenue cycle information and cash
conversion cycle suddenly has a powerful set of information to draw conclusions
about a company’s performance and management’s current strategy.
Evaluating the strength
of a company’s operating activities by “connecting the dots”
A. Revenue Related
Activities
The revenue recognition
criteria is quite straightforward for the Flower business model and thus they do
not have Deferred Revenues in the liability section of their balance sheet. The key pair of accounts then, are Sales
Revenues and Accounts Receivable. We
expect to see approximately the same rate of growth for each.
Here we will exploit
Valuation Tutor’s Data Collector to collect together Sales and Accounts
Receivable.
To do this bring up each
statement and then double click on the fields you want to gather together:
Then plot the
relationship:
Observe there has been a
sizeable growth in Accounts Receivable relative to the Sales growth. This is a potential flag. The picture below provides a quick check for
whether this is seasonality or whether some negative trend is developing by
checking the current versus the previous quarter:
It is clear there is a
trend for greater Accounts Receivable growth rates relative to Sales Revenue
growth rates. However, there is one
important factor we are currently overlooking and this is the impact of
seasonality upon the financials. Given
the current data at hand seasonality cannot be fully analyzed and thus we will
return to this issue later in this lesson.
Cost of Revenue Related Activities
In this section we
repeat the use of the data collector to depict the Cost of Sales Cycle. We will use a second Tab View (Tab View 3) in
Valuation Tutor so we can preserve the revenue results (in Tab View 2) as
depicted above.
Here the cost side is
expanding but there is evidence of stretching the Accounts Payable and
Inventory relatively more. The above
pattern is in stark contrast to the older pattern where Cost of Sales was
relatively much smaller.
From visually analyzing
the revenue and cost of revenue cycles it would appear that a few negative
flags are raised. On the revenue side
the growth rate for accounts receivable far exceeds the growth rate for
sales. This could suggest very loose
credit to generate sales. On the cost
side the cost of sales has increased significantly and there is some evidence
of both inventory build up as well as delaying paying creditors presumably as a
source of liquidity.
These conjectures can be
further analyzed by studying the Cash Conversion Cycle. We turn our attention to this next.
The Cash Conversion Cycle
The three working
capital accounts from the latest 10-Q are Accounts Receivable, Inventory and Accounts
Payable. Observe these are important
accounts for both the Revenue and Cost of Revenue Cycles. We can now extract additional information
regarding these three important account balances by converting their turnover
analysis into average days.
For the case of Sales and COGS the accounting time periods are
3-months and 6-months respectively:
If we work with 6-months as our accounting period then the
numerator for converting a turnover into days is 182.5 and if 3-months then
91.25.
Collecting Data
Together:
Using the data reported in the two interactive 10-Q’s provided we
can pull of the following analysis:
First, to complete the analysis we need the Balance Sheet numbers
from December 26, 2010 which was not provided in either of the current 10-Q’s. Working back with earlier filings we can get
this data using the Information Browser in Valuation Tutor from an earlier
filing. It turns out that this prior
filing was amended and so it is a Form 10Q/A which indicates amended:
The key numbers here are the Accounts Receivable, Inventory and
Accounts Payable plus we will run an additional check to see what the released
Sales and COGS were in the amended report versus to what is reported in the
current 10Q’s. These turned out to be
different and thus we will use both sets
of numbers below. The numbers from the
Amended 10-Q are highlighted in red:
Cash Conversion Cycle
(3-months and 6-months)
The above analysis has controlled for seasonality by working with the December 26, 2010 Balance Sheet Information. In addition, the Amended columns work with the amended revenue and COGS numbers to compare against the numbers pulled directly from the filings.
Overall, the evidence from operating activities is mixed for
1-800-Flowers.
Days to turnover inventory and pay payables have increased (and
even more with the amended numbers) whereas days to collect receivables have
improved. Overall, the cash conversion cycle is kept
tight and currently negative because the days to pay payables have been extended
beyond the combined effect of slower sales that results
in holding inventory longer, and shorter receivable collection times.
Implications from the
Analysis for Business Strategy
From management’s perspective we would expect to see emphasis
being placed upon Sales and Marketing given the above numbers have revealed
slowing inventory turnover. In addition
Research and Development in relation to technology should also be an important
variable for management because a lot of their business is likely to be
conducted over the web. Turning to these
numbers from the latest 10Q we observe the following:
That is, Sales and Marketing expenditure has increased along with
a marginal increase in Technology and Development.
Conclusions
The above exercise illustrates how you can connect the dots with
the firm’s operating decisions. Other
major decisions such as investing activities, financing activities and dividend
activities can be subjected to similar close scrutiny. The overriding purpose is to evaluate
management’s strategy and effectiveness when implementing the firm’s business
model. It is also noted that the above
analysis has been performed using only the firm’s own financials. Later parts of Valuation Tutor allow you to
take this to the logical next step by comparing across firms and with
competitors.
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