28 May 2007

Enhancing the Cash Management Gauge

We have used the following five ratios, mostly derived from the Balance Sheet, to calculate the Cash Management Gauge:
The two ratios involving Inventory are overweighted, relative to the other three figures, such that Inventory influences half of the Cash Management gauge score. The overweighting reflects our belief that Inventory data can reveal much about current and future business conditions at manufacturing companies and how deftly corporate managers are handling these conditions. Manufacturers buy raw materials, fabricate or assemble these items, and output finished goods for sale. The various components of Inventory give us insight into each step.

A microsecond of further thought suggests that services such as financing, marketing, and transportation are also important. Banks, advertising firms, and shippers have, to name three, long provided services to manufacturers and other companies. Today, work that manufacturers traditionally performed in house, such as design or payroll processing, is being contracted out to specialty service firms.

Service firms, such ADP (IT services) and TDW (marine services), might have capital equipment in abundance, but they don't have Inventory in the same sense as manufacturers. The notion of Inventory also differs when we consider retailers (all inventory is product ready for sale), energy companies (inventory value varies with commodity prices), electric utilities (the final product is hard to store), and software companies (the raw material is intellectual property).

It should be clear from the preceding that an inventory-weighted Cash Management gauge is less applicable, to one extent or another, to service companies than manufacturers. Not surprisingly, we've seen the gauge behave erratically when evaluating service companies.

In an attempt to address this problem, we have identified three additional cash management ratios as candidates to broaden the gauge calculations. We will experiment with these parameters when analyzing second quarter financial statements. We will then evaluate each candidate to determine if it added to the analysis process or not.

The three candidate ratios are:

Working Capital / Market Capitalization. We learned about this ratio from the Motley Fool. Working Capital is Current assets minus Current Liabilities. Market Capitalization is Market Value + Debt. Market capitalization is, therefore, an approximation for the true cost to an acquirer. A greater percentage of working capital would presumably be attractive to the acquirer. For this reason, the ratio might also be considered for the Value Gauge.

Debt/CFO. The ratio indicates how many years of operating cash flow are required to pay off the company's short-term and long-term debt.

Cash Conversion Cycle (CCC) Time. This one is a little complicated, but it is well explained here. Short CCC times indicate that the company is using its working capital efficiently. The CCC time is the sum of days of inventory [Inventory/(CGS/day)] and days of sales outstanding [Receivables/(Revenues/day)], less days of purchases outstanding {Accounts payable / [(CGS+ increased inventory)/day)]}. Note that the first two terms show the company consuming working capital for inventory held and sales for which customers haven't yet paid. We subtract the working capital the company is "saving" by not yet paying for its own purchases.

In computing the Cash Management gauge score, we're going to give 1 point for each 2 percent reduction in the CCC time, each 2 percent reduction in Debt/CFO, and each 1 percent increase in Working Capital to Total capitalization. As we gain more experience with these ratios, it is likely that we will adjust the scoring.

We will weight our five original and three new ratios, relative to each other, as listed below:
  • Current ratio: 5
  • LTD/Equity: 10
  • Finished Goods/Inventory: 20
  • Receivables/Revenue: 17.5
  • Inventory/CGS: 5
  • Working Capital / Market Capitalization: 22.5
  • Debt/CFO: 10
  • Cash Conversion Cycle Time: 10
If a ratio doesn't apply to a particular company under analysis, the weight for that ratio will be zero.

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