How do you evaluate the current and future financial health of a firm? This is an important first question (in this book we will initiate much of our discussion with questions which will be in italics). If you are considering lending money to a firm, acquiring a firm, or entering into competition with one, you want to assess its financial health before making your decision. Answering the question above involves three of the most basic tools of corporate finance: ratio analysis, sources and uses, and pro formas. We will discuss the first two, ratio analysis and sources and uses, in this chapter, and pro formas in the next.

We begin the process of answering this question by using a fictional medium-sized firm in the plumbing supply business. The firm is located in Pinellas County, Florida (near St. Petersburg). We call it Pinellas Plumbing Equipment and Supply (PIPES).

PIPES has been in business for 15 years, and its founder and current owner, Ken Steele, is preparing to meet a local banker, John Morgan, to discuss a possible loan. PIPES currently has a line of credit with another local bank for $350,000.

What kind of questions should Mr. Steele expect from the banker? John Morgan, the banker, might begin by asking Mr. Steele to describe the company to him. Why would Mr. Morgan ask Mr. Steele for a description of a business he already knows about, seeing that he is from the same small town? Because Mr. Morgan first wants to see if Mr. Steele understands his own business. Steele describes his company as a plumbing supply business, serving both homeowners and contractors, with a solid customer base. The firm has a product line ranging from pipes and fittings to bathroom and kitchen fixtures (including tubs, toilets, sinks, and faucets). It maintains a 6,000-square-foot showroom plus an additional 24,000 square feet of warehousing and offices.

The banker’s next question is likely to be: How long have you been running PIPES? This is a key question. It makes a big difference to Morgan and his bank whether Steele is starting a brand-new business or has already run the business for 15 years. A 15-year track record means the business has a customer base, regular suppliers, and so on. Furthermore, it means there is a record for Morgan to evaluate when considering the loan.

The Conversation with the Banker Is Like a Job Interview

Ultimately, the banker wants to determine the competence of the management team and the health of the firm before deciding whether or not to issue a loan. Mr. Steele is trying to present himself and PIPES in the best possible light. He should have prepared at least three years of financial statements for Morgan. In fact, Steele hands Morgan Table 2.1—the firm’s Income Statements and Balance Sheets—for the past four years. From the Income Statements, PIPES appears to be doing well. Sales have grown from $1.1 million in 2009 to $2.2 million in 2012. This is an average growth rate of 25% a year. Is this good? It certainly beats the economy as a whole (by a wide margin) and for a plumbing store in a medium-sized town, it seems exceptional. However, PIPES’s Balance Sheets are not as clear: Total assets and debt (bank and long-term) have grown by less than 25% a year, but accounts payable have almost tripled over the four-year period. First impressions, however, are just that. A more detailed analysis is required.

In this chapter we will analyze PIPES starting with its position in the product market. We will then analyze its financial health and in so doing perform ratio analysis. Next we will ask: what are the sources and uses of its funding? In the following chapter, we will show how to forecast the firm’s future viability.

Starting with the Product Market Strategy

How does PIPES make money? This is another way of asking: what is the firm’s product market strategy? As we will repeat several times in this book, every firm operates in two markets—the product market and the financial market. Your authors firmly believe that you cannot do corporate finance unless you understand both markets. Even further, in determining a firm’s financial health, you always begin by analyzing its product market because that’s where the profits are made. Good financing can help, and bad financing can hurt or even ruin a firm, but the key to a firm’s success is in the product market.

To understand PIPES, we begin with its product market. A plumbing supply store is largely a commodity business: the firm is selling many products that are similar (if not identical) to those found at other plumbing supply stores. This means customers buy primarily based on price and secondarily on service. If the firm prices its products too high, then customers are likely to use another supplier. Pricing too high may also encourage a new competitor to enter the market. Thus, being in a commodity business means that PIPES is unable to increase prices beyond the rest of the market, so it needs to control its costs to ensure adequate profit margins.

What about service? What does service mean for a plumbing supply store? Basically, if someone walks into the store looking for a product, the firm must have it in stock. If a potential customer is looking for a particular type of standard pipe, and Mr. Steele says he doesn’t have it but will order it and have it in three weeks, the customer is likely to either go to another store or order it himself online. Remember, PIPES is in a commodity business, so customers can get similar or identical products from other suppliers.

Additionally, while some of the firm’s customers are homeowners, many of its customers are local contractors. Service to contractors generally means they expect PIPES to extend them credit. Contractors often don’t get paid until they complete their work, which could be in several months. As such, they don’t want to or may be unable to pay PIPES until after they themselves get paid. Together with stocking the items customers need, this means that PIPES is both a warehouse and a bank for this customer segment.

Therefore, PIPES’ success in the product market starts with competitive pricing. In addition, it is important for PIPES to have adequate inventory. Finally, PIPES must be able to extend credit to their best customers. Both carrying inventory and extending credit require PIPES to have sufficient financing, either from the owner’s investment (including prior earnings retained in the business) or from funds borrowed from others (in this case, primarily bank loans).

Is PIPES Profitable?

Is PIPES profitable? As seen in Table 2.1A, the firm’s net income last year was $83,000. Is that a lot? The firm’s net income is not large in absolute terms compared to a Home Depot or a Lowe’s, whose profits are in the billions. However, profitability is more than absolute dollar amounts. For instance, it is important to consider how much profit a firm makes on the amount sold or the amount invested. A firm’s net sales margin (profit/sales) tells us how much profit the firm makes per dollar of sales. For PIPES, the net sales margin was 3.8% in 2012. This means that for every $100 of sales, PIPES made a profit of $3.80. A comparable number for Home Depot in 2012 is $6.06 (based on Home Depot’s 2012 annual report).

We are also very interested in how much profit a firm earns given the amount invested. That is, we consider profit versus the capital the firm has invested. We can do this by looking at Return on Assets (ROA) or, if we are interested in the equity investment of the owners, by looking at the Return on Equity (ROE). These two ratios give us a sense of the return a firm obtains versus the amount of capital at risk. It also allows us to compare this return with other investments.

Profitability Ratios:

To repeat, PIPES’s 2012 net income was $83,000, total assets at year-end were $1,052,000, and equity (contributed capital and retained earnings) at year-end was $354,000. Using these numbers yields an ROA of 7.89% ($83,000/$1,052,000) and an ROE of 23.45% ($83,000/$354,000). The comparable return numbers for Home Depot in 2012 are 11.06% and 25.5%, respectively.

Doing the Math

There are many different ways to calculate ratios, and numerous ratios are used in finance. The most important rule in using ratio analysis is to make sure that you are consistent across the firm and across the industry.¹ This point may seem obvious, but it is surprising how often ratios are not calculated in the same way when comparing different firms or the business activities of a single firm over time.

Consistency means not only using the same ratios or formulas; it also means using the correct time period. Let’s use a simple example: Think about depositing $10,000 in a bank on January 1. At the end of the year, you receive your statement and see your interest for the year was $1,000, bringing your year-end balance to $11,000. What is the return on your investment for the year? It is 10% (the year’s earnings of $1,000 divided by the initial investment, or opening balance, of $10,000). However, when we calculated ROA (ROE) above, we divided the income for the year by the assets (equity) at year-end. This calculation is comparable to dividing the $1,000 of interest by the $11,000 year-end balance, giving a return of 9.1%, which is not correct. To accurately measure the yearly return on the assets invested, we need to divide the total yearly income by the initial investment, which is the beginning-of-the-year amount of total assets or equity.

• Initial Investment on January 1st = $10,000
• Ending Investment on December 31st = $11,000
• Earnings = $11,000 – $10,000 = $1,000
• Return on investment = ?
• The correct return calculation is: Earnings/Initial Investment = $1,000/$10,000 = 10%
• The incorrect calculation is: Earnings/Ending Investment = $1,000/$11,000 = 9.1%

Analysts often mistakenly divide income by end-of-year assets or equity to determine ROA or ROE.² They do this because the numbers are readily available on each year’s Income Statement and Balance Sheet. In contrast, many textbooks, when dividing an Income Statement number by a Balance Sheet number, average the Balance Sheet number over the year. The average is usually computed as the average of the begin-of-year (which is the same as the end of the previous year) and end-of-year balances. This alternative may make sense if a firm is growing rapidly and additional investments are being made during the year. However, in general, the opening numbers provide a more realistic ratio. In this case, using the opening numbers increases PIPES’s ROA to 9.22% ($83,000/$900,000) and ROE to 30.63% ($83,000/($75,000 + $196,000)). By comparison, Home Depot’s ROA and ROE done this way are 11.19% and 25.34%.

Thus, to restate the paragraph above, PIPES earns less profit than Home Depot in both total dollar amount and as a percentage of sales. However, PIPES’s return on amount invested is, as recalculated, now lower than Home Depot’s on ROA but higher on ROE. Table 2.2 provides a number of profitability ratios calculated in a number of ways.

Table 2.2 does not even begin to cover all the possibilities of profitability ratios. For instance, we can also use Earnings before Interest and Taxes (or Operating Profit) instead of Net Income as both a stand-alone value and as a numerator for ROA or ROE. As another example, we can calculate Return on Net Assets (RONA) instead of ROA. Net Assets are the firm’s fixed assets plus net working capital (cash plus accounts receivable plus inventory less accounts payable). Our point is simply that there are many ways to compute ratios. Today, with the ease of computer spreadsheets, the number of ratios is not going to decrease. As stated above, the most important rule with ratio analysis is consistency.

Returning to our banker’s investigation: Is PIPES profitable? Does it have a good ROE? Yes, an ROE of 30.63% is actually quite good. A net income of $83,000 may look small next to the $4.5 billion earned by Home Depot in 2012, but PIPES’ ROE is right up there, exceeding Home Depot’s 2012 ROE of 25.34%. PIPES is, therefore, doing well in terms of its return on its owners’ investment.

Sources and Uses of Funds

This brings us to our next question: If PIPES is profitable, why does it need to borrow money? PIPES needs to borrow money because it is not generating enough profits to finance its growth. Is this a bad thing? It is neither good nor bad. At some point, most successful firms grow faster than they are able to finance through internally generated funds. That’s why capital markets exist. Debt and equity markets would not be required if all firms could finance themselves out of retained earnings (remember, retained earnings are internally generated funds—they are accumulated profits remaining after all expenses and dividends are covered). PIPES needs to borrow funds because it is growing faster than it can internally sustain.

What does PIPES need the funds for? To understand the flow of funds in and out of a firm (i.e., what the funds are used for and where a firm obtains its financing), we introduce another financial tool: the Sources and Uses of Funds.

Let’s begin with Sources: What are the sources of funds for a firm? A firm has more funds if it reduces its assets or increases its liabilities and net worth. For example, if a firm sells an asset, it is a source of funds. If a firm issues debt or sells equity, it is also a source of funds.

Turning now to Uses: What are the uses of funds for a firm? They are the reverse of the sources of funds. If a firm increases its assets, it is a use of funds. Likewise, if a firm pays down debt, repurchases equity, or pays a dividend, it is also a use of funds. Profits that become retained earnings are a source of funds, while losses that reduce retained earnings are a use of funds.

• Sources are: Assets ↓ or Liabilities ↑ or Net Worth ↑
• Uses are: Assets ↑ or Liabilities ↓ or Net Worth ↓

We can now create a Sources and Uses of Funds Statement by looking at the changes in PIPES’s Balance Sheet at two points in time. Looking at the Balance Sheet in Table 2.1B, we can create Table 2.3A the Sources and Uses Statement for 2012 by comparing the ending balances in 2011 (which are the opening balances for 2012) with the ending balances in 2012:

Going line by line in the asset half of the Balance Sheet:

• Cash increases from $40,000 to $45,000. Since an asset went up, this $5,000 is a use of funds.³
• Accounts receivable increases from $165,000 to $211,000. This is also a use of funds. Remember, accounts receivable is an asset (customers owe the firm money and have not yet paid; PIPES is effectively extending credit to its customers). Importantly, all else equal, the firm has to somehow fund this $46,000 increase in accounts receivable. This is similar to its funding any other asset, such as a new forklift.
• Next, we see inventory increases from $340,000 to $418,000, which is a $78,000 use of funds. By the same logic as for accounts receivable, PIPES has to fund this $78,000.
• Prepaid expenses decreases from $30,000 to $28,000. In this case, an asset has gone down, which is a $2,000 source of funds.
• Property, plant, and equipment increases from $325,000 to $350,000, which is a $25,000 use of funds.

Now, we turn to the other half of the Balance Sheet, liabilities and equity:

• There is no change in the current portion of long-term debt, so this is neither a source nor a use.
• Next, we see that the bank loan stayed constant at $350,000. Again, this is neither a source nor a use.
• Accounts payable (or trade credit—the amount that PIPES owes to its suppliers of goods and services) increased from $144,000 to $223,000. An increase in liabilities is a source of funds, and so this is a $79,000 source of funds. This $79,000 reduces the firm’s need for external financing.
• There is no change in accruals, so this is neither a source nor a use.
• Long-term debt falls from $100,000 to $90,000. Since the liability decreases, this is a $10,000 use of funds.
• There is no change in contributed capital, so this is neither a source nor a use.
• Retained earnings increases from $196,000 to $279,000, which is an $83,000 source of funds. This is 100% of the firm’s net income for the year, which means PIPES did not pay any dividends to its owners. Net income is a source of funds, while dividends paid are a use.

Note that in Table 2.3A, the Total Sources of Funds and Total Uses of Funds are both $164,000. It is considered aesthetically pleasing (as well as financially necessary) that sources equal uses. If sources don’t equal uses, it means you have a mistake someplace, for instance, you classified something incorrectly, and you need to go back over your numbers to find the mistake.

Table 2.3B summarizes PIPES’s Sources and Uses from Table 2.3A. The largest sources and uses are highlighted in bold.

Why are we computing the Sources and Uses of Funds? To help us determine what areas of the Balance Sheet to focus on. Where are the main uses of funds for PIPES? That is, what have its funds been primarily used for? Examining the Sources and Uses Statement shows that the largest use items are accounts receivables of $46,000 and inventory of $78,000. PIPES’s increase in cash is minor and not worthy of a first-pass examination, and its increase in PP&E of $25,000 seems reasonable for a growing business.⁴ Do these uses of funds make sense? Yes, they do. PIPES has increased sales by 25% a year, and to do so, it has had to extend more credit and carry more inventory.

Examining Table 2.3B, what are PIPES’s primary sources of funds? Accounts payable of $79,000 and retained profits of $83,000. Mr. Steele has been in a competitive business for 15 years, increasing sales significantly while showing a profit. The Sources and Uses Statement shows that PIPES put most of its funds last year toward receivables and inventory, and that PIPES is getting most of its funds from trade creditors and retained profits.

So what do these increases in accounts receivables and inventories mean? Can receivables ever be too high? Yes. Mr. Steele could be giving credit to customers who are not paying or are taking too long to pay. Remember, his receivables are being partially funded by bank borrowings, on which he has to pay interest. Can receivables be too low? All else being equal, Mr. Steele would certainly prefer them to be lower. However, to get receivables lower, he would have to restrict credit to customers, which may cause them to shop somewhere else that provides more lenient credit. As noted above, extending credit is a service provided by PIPES and is part of what makes the firm competitive in the product market.

Can inventories ever be too high? Absolutely. What does it mean if inventory is too high? It means Mr. Steele has ordered too much product, which is sitting on his shelves, incurring unnecessary storage, insurance, and financing costs. It could mean he has been ordering the wrong inventory—products that people don’t want and are not buying, which he may eventually have to scrap at a loss. Can inventory be too low? Without a doubt. If the product customers are looking for is not in stock, they go elsewhere. PIPES must balance having sufficient quantity of inventory that customers want with the cost of having too much inventory.

PIPES, as noted earlier, is both a warehouse and a bank for its customers. The firm must have the right level and kind of inventory and be willing to extend credit to its customers.

So, in essence, the banker interviews Steele and examines PIPES’s Income Statement and Balance Sheet to determine the following: Is this firm financially healthy and well run? Mr. Morgan can see that sales are growing and the firm has been reasonably profitable. In the personal interview, Mr. Morgan is also trying to determine if Mr. Steele has the ability to run the business (ordering, stocking, dealing with customers, accounting, etc.) or if someone else ran the operations (perhaps his wife). Moreover, he wants to know: Is there anyone else who can run the firm if something happens to Mr. Steele?

Ratio Analysis

How can the banker determine if the firm is well run? For this we use another of our other financial tools: ratio analysis, which we introduced earlier when we discussed profitability. Ratio analysis helps us to determine whether a firm is well run or not. Ratio analysis measures the firm’s performance and financial health. Ratios can be used to compare the firm with itself over time and to compare the firm with other firms in its industry either at a point in time or over time.

There are four main categories of ratios:

1. Profitability ratios, some of which we have mentioned earlier (e.g., Return on Sales, Return on Assets, Return on Equity, etc.)
2. Activity ratios (also called operating ratios or turnover ratios), which include Days Receivable, Days Inventory, Days Payable, and so on and which focus on the firm’s operations
   • Days Receivable = Accounts Receivable/(Sales/365)
   • Days Inventory = Inventory/(Cost of Goods Sold/365)
   • Days Payable = Accounts Payable/(Purchases/365)
3. Liquidity ratios, which indicate how liquid a firm is—whether the firm has the ability to pay its current debts as they come due—and includes the Current Ratio and the Quick Ratio
   • Current Ratio = Current Assets/Current Liabilities
   • Quick Ratio = (Cash + Marketable Securities)/Current Liabilities
4. Debt ratios, which indicate how much of a firm’s funding is financed with debt instead of equity and include Debt/Equity, Debt/Total Assets, Leverage Ratio, Times Interest Earned, and so on
   • Debt/Equity = Interest-Bearing Debt/Owner’s Equity
   • Debt/Total Assets = Interest-Bearing Debt/Total Assets
   • Total Assets/Equity Ratio = Total Assets/Owner’s Equity
   • Times Interest Earned = Earnings before Interest and Taxes/Interest Expense

We often calculate all of our ratios as a percentage of sales. These are called common size ratios, and all components of the Income Statement and Balance Sheet are presented as a percentage of sales. This allows for comparisons over time (both to itself as well as to other firms), eliminating the impact of differences in size, and provides a starting point for pro forma forecasts. As can be seen in Tables 2.4A and 2.4B, the components of PIPES’s Income Statement and Balance Sheet have been very consistent over time as a percentage of sales.

Common size Balance Sheets can also be stated as a percentage of total assets. Your authors prefer percentage of sales, although properly done both give the same answer.⁵

Ratios are calculated in many different ways. As noted above, when we talked about profitability ratios, the numbers used from the Balance Sheet can come from the start of the year, the end of the year, or the average over the year. The ratios can be stated as a percentage of sales or as a percentage of cost of goods sold. Activity formulas can be stated in number of days or in number of turns (defined below). Why so much variation, and what is the difference? The variation chosen is often a personal preference of the analyst. Most importantly, all of the ratios can be translated into one another. For example (as seen in Table 2.5), inventory can be stated as a percentage of sales or as a percentage of cost of goods sold, as days of inventory or number of inventory turns in a year. However, each of these ratios can be translated into the other.

Table 2.5 presents selected activity, leverage and liquidity ratios for PIPES several different ways. (Note: Table 2.2 already presented selected profitability ratios so these are not repeated here. Normally all the ratios would be presented together on one sheet of paper or spreadsheet.)

Let’s briefly discuss the translation of the ratios from percentage of sales to turns to days using a simple example.

Receivables as a percentage of sales (i.e., % receivables) is calculated (in 2012) as:

• Accounts receivable/sales = $211,000/$2,200,000 = 9.59%

Receivable turnover is calculated as:

• Sales/accounts receivable = $2,200,000/$211,000 = 10.43

These two are simply inverses of each other (1/9.59% = 10.43 and 1/10.43 = 9.59%).

Days receivable is calculated as:

• Accounts receivable divided by the average daily sales = $211,000/($2,200,000/365) = 35.01

Days receivable is also 365 times the % receivables (365 * 0.0959 = 35.01) or 365 divided by the receivable turnover (365/10.43 = 35.01). All three ratios are merely transformations of one another.

The same relationships hold true for items such as inventory as a percentage of cost of goods sold (COGS), inventory turnover, and days inventory, where:

• Inventory as a % of COGS = Inventory/COGS
• Inventory turnover = COGS/Inventory
• Days Inventory = Inventory/(COGS/365) or 365 * Inventory as a % COGS

A suggestion: Until (or unless) the reader is comfortable with or develops a preference for specific ratios, your authors suggest you primarily use percentage of sales. This is the easiest of the many ways to compute pro forma (forecasted future) Income Statements. We recommend it highly. As shown above, it can be translated into any of the other ratios (i.e., days, turnover, etc.). In that vein, much of the following analysis for PIPES will be done as a percentage of sales.

How do we interpret the ratios? Ratios differ by industry. For example, retail grocers will have low profit margins on sales with high turnover ratios. The grocer doesn’t make much on each individual sale, but the grocer will turn its inventory over many times a year (and do so with very low receivables or fixed assets). Imagine a particular grocer has an inventory turnover of less than 52 times (which translates to once a week). Assuming this is an old-fashioned grocer selling only meat and produce (no bakeries, canneries, refineries, wholesale divisions, etc.), this means the produce and meat are sitting on the grocer’s shelves for more than a week on average. As consumers, let alone investors, you should probably avoid this grocer. On the other hand, a firm with larger margins than a classical grocer may have a lower turnover. For example, Ford Motor Company has a 4.4% net profit margin (net profit/sales) while turnover (on sales) is 17.2 for inventory, 5.1 on fixed assets, and 0.67 on total assets. Likewise, PIPES should have higher margins but lower turnover than a grocer.

Because ratios depend on the business the firm is in, ratios must be used in comparison to other ratios. As mentioned above, the two common ways to do this are to compare the firm to itself over time and to compare the firm to other firms in the same industry in the same time period. A ROE of 30% means much more to us if we see that this is the highest it has been in the past five years or if this is higher than competing firms.

Table 2.4A above gives the percentage sales ratios for each item on PIPES’s Income Statement for the past four years. For example, COGS was 77.1%, 77.2%, 77.1%, and 77.0% for 2009 through 2012. This stability suggests that nothing dramatic changed in the markup between the costs of PIPES’s inventory and selling price. The gross profit, which is sales minus COGS, remained very close to 23% throughout the period (actual numbers are 22.9%, 22.8%, 22.9%, and 23.0%, as shown on the next line in Table 2.4A).

The Cash Cycle

Let’s back up for a moment and talk about the cash cycle. Consider a point in time—we’ll call it time zero—when PIPES purchases some inventory. What happens to the inventory? Other than, perhaps, perishables in a supermarket, most firms do not sell their inventory the day it is purchased. The inventory goes into a stock room and then is hopefully sold. How long does it take before PIPES sells its inventory on average? This is the days inventory ratio, which in 2012 is 90 days for PIPES. However, selling the inventory is not the same as getting paid for the sale. In general PIPES does not get paid at the time of sale, since it extends accounts receivable. How long does it take before PIPES gets paid? The accounts receivable are paid over time. If a customer pays cash, the accounts receivable is zero days. Furthermore, if a customer uses a credit card, there is a period of time before the credit card company deposits the cash into PIPES’s bank account. In 2012, PIPES’s accounts receivable averaged 35 days. This means it took 125 days on average from the time PIPES purchased its inventory until it was sold and paid for (90 days of inventory and 35 days of accounts receivable).

If PIPES paid for its inventory on the day it purchased it, then the 125 days represents the time period over which PIPES must finance its inventory and receivables. Table 2.1B shows that in 2012, inventory and accounts receivable totaled $629,000 at year-end ($211,000 + $418,000). PIPES must finance this amount either from retained earnings or by borrowing. However, inventory and accounts receivable are only part of the cash cycle. PIPES does not pay for its inventory on the day they purchase it. They pay later and this is represented by accounts payable (PIPES’s accounts payable are accounts receivable to the firms it purchases from).

What about PIPES’s accounts payable? How long does it take PIPES to pay off its accounts payable? On average 46 days. Is this long? It depends. PIPES’s suppliers would certainly like their funds sooner; however, PIPES would like to wait to pay for the goods until it receives payment from its customers. In this sense, PIPES is using its accounts payable to help fund its receivables and inventory. If accounts payable are greater than accounts receivable plus inventory, then the firm is using the accounts payable to fund other assets as well. In our case, PIPES uses accounts payable to finance 46 days of inventory and receivables.

So accounts payable are also part of the cash cycle. It may help to look at the summary that follows, which represents the entire cash cycle. PIPES takes 125 days to sell and collect payment for purchases. However, PIPES takes 46 days to pay its suppliers, which leaves 79 days of inventory and receivables that must be financed in other ways.

The cash cycle represents two sides of a firm’s cash flows. The first half represents the time that the firm holds the product as inventory plus the time until customers pay their accounts receivable. The second half represents the time until the firm pays its accounts payable to its suppliers plus the additional time the firm must finance: the net difference in the inventory, receivables, and payables collection periods.

We described the PIPES cash cycle above, but cash cycles vary across industries and firms. For instance, a grocer’s cash cycle may be much shorter since a grocer will sell most of its inventory very quickly, doesn’t extend credit, and buys from suppliers who demand prompt payment.

The cash cycle represents one need or source of financing for a firm. Conceptually, it is important to realize that inventory and receivables must be financed (they are a use of funds) and that accounts payable can help mitigate this financing need (which is a source of funds).

So is an increase in accounts payable good or bad? Increasing accounts payable is great as long as it does not cost the firm anything. However, at some point, if they are not paid soon enough, suppliers will include a fee for late payment, raise prices, or simply stop selling to a firm. Often suppliers offer terms to entice customers to pay sooner. A common discount is 2/10 net 30, which means if the firm pays in 10 days it can take 2% off of the price, otherwise the full amount (net) is due by day 30. Suppose this holds true for PIPES. In 2012 PIPES’s purchases (as shown in Table 2.1) were $1,773,000. If PIPES was able to take a 2% discount on the purchases the savings would be $35,460. This means PIPES would have an extra $35,460 in profit before interest and taxes. Is this a lot? YES! Since PIPES’s profit after taxes was $83,000, an extra $35,460 is huge. However, that $35,460 is not free money. If PIPES reduces accounts payable from 46 to 10 days to take the discount, it will have to finance the extra 36 days, which is a cost.

At this point we are going to introduce a topic that is dealt with in detail later in the book. That is, we won’t explain the topic fully, but instead will “shell the beaches.”⁶ We are going to introduce the idea of the cost of payables versus the cost of financing. We won’t do it formally here but will later in the book when we look at investments.

If PIPES pays all its suppliers on day 11 instead of day 10, and loses the 2% discount by paying one day late, this is the equivalent to an annual interest rate of over 700% (annualize the daily rate of 2% by: 2% * 365 days). Of course, PIPES is not paying on day 11. Right now, the suppliers are allowing PIPES to take 46 days to pay (based on purchases) and effectively are partially funding PIPES’s sales growth. This means the discount lost is 2% for 36 days (46 days – 10 days) or an annualized rate of about 20% a year (2% * 365/36). (There is an old finance phrase, “collect early, pay late,” which captures this idea.)

Going forward, we will assume for our analysis that PIPES’s suppliers have informed the firm that starting in 2013, PIPES can pay on day 10 and obtain a 2% discount or pay by day 30 with no discount. If PIPES pays any later, it is assumed the suppliers will start charging PIPES higher prices or stop selling to it altogether. Thus, PIPES is no longer able to wait 46 days before paying its suppliers; it must pay within 30 days. This change means that future projections for accounts payable must be set at less than 30 days of purchases. Let’s further assume that PIPES decides to pay its accounts payable in 10 days. (We next address whether that is the right time period. Hint: It is.)

Annual purchases, as we see from Table 2.1A, are $1,773,000. A 2% discount on this amount is $35,460. To obtain this discount, PIPES must pay on day 10 instead of day 30. To pay on day 10, PIPES will have to finance an extra 20 days of payables (the difference between paying on day 30 and day 10). The amount of extra financing required is computed by multiplying the average daily purchase by 20 days. The average daily purchase is $4,857 ($1,773,000/365). The extra financing is the average daily purchase times 20 days = $97,151. Financing a $97,151 increase in payables at an assumed 7% interest rate will cost PIPES $6,801 ($97,151 * .07). Clearly PIPES should pay on day 10, as it results in an increase of profit before tax of $28,659 ($35,460 – $6,801) or an increase in net profit of $18,628 ($28,659 * 65%).

Another way to understand this is that PIPES is now looking at a 2% discount on a 20-day time period (the difference between paying on day 10 and day 30). If PIPES decides to pay on day 30, it will pay an approximate annual interest rate of 36% (PIPES is paying 2% for each 20 days period; since there are approximately eighteen 20-day periods in a year, this is approximately a 36% (18 * 2%) annual interest rate). Borrowing from the bank at 7% is better than paying suppliers an implicit interest rate of 36%.

So why didn’t PIPES do this? PIPES simply did not have the funds to pay receivables on day 10 with a $350,000 bank line of credit.

Another comment on Accounts Payable: firms can often push a little bit past each of the deadlines. If PIPES paid on day 14 and still took the 2% discount (or paid on day 35 without the discount), the suppliers might roll their eyes and accept it since they don’t want to lose a customer. We don’t know the exact limits here, and the assumptions can be altered to fit any specific situation. The longer a firm takes to pay a supplier, all else being equal, the lower the cost. However, as noted above, at some point the suppliers will charge for financing (directly or indirectly) or will simply stop selling to the firm.

Summary

1. We have introduced PIPES, a medium-sized plumbing supply store, which we are using to demonstrate how to evaluate the financial health of a firm. What is the active question PIPES is trying to figure out? It is trying to determine how much money it needs to fund future operations. The inverse question, which the bank is trying to figure out, is how much money to lend to PIPES.
2. To examine the financial health of a firm, we must start by understanding the firm’s product market. Finance may help a firm survive and prosper, but ultimately the firm’s success depends on its product market business, so that is what we must focus on first. What are the crucial factors for a medium-sized firm in the plumbing supply industry? We determined they were price and service. Price came first because plumbing supplies is an industry with low barriers to entry and involves a commodity product. This means price is a very important part of doing business. Service came second, and in this industry service includes both having the necessary inventory in stock as well as providing credit (acting as a bank) to some of the firm’s customers.
3. We then asked: Is the firm profitable? We found that PIPES did not make a large profit in an absolute sense, but its ROE of 30.6% indicates Mr. Steele is probably doing a good job.
4. Next, we demonstrated that even though a firm is profitable, it may have to borrow funds. This occurs when a firm is growing faster than its retained earnings (we will discuss the concept of sustainable growth in detail in Chapters 5 and 9). We note that PIPES’s profits are insufficient to fund the growth in receivables and inventory. To date, PIPES has funded itself primarily with some bank debt and an increasing amount of trade credit (credit from its suppliers, or accounts payable).
5. We then examined PIPES’s Sources and Uses of Funds. Why did we look at this? To understand what the firm’s money is being used for and where the firm is obtaining it. This is an important tool, which allows managers and analysts to recognize potential problems.

6. Next we used ratios, another financial tool, to examine the firm and see how PIPES was doing. Your authors wish to stress the importance of always starting the analysis of a firm with ratios. You can read any analyst report, and you will see they always start with ratios, comparing the firm to others in the industry as well as to the firm’s own past. CFO presentations almost always begin with ratios. Bankers will almost always start their loan reviews with the firm’s ratios. The reader should remember how his or her views of PIPES changed after going through the ratios.

   Ratios are the diagnostic that finance begins with. When someone goes to a doctor’s office, regardless of the reason for the visit (e.g., a sore throat, an ear ache, or an annual exam), the doctor or physician’s assistant begins by taking the person’s blood pressure, pulse, and temperature. These are diagnostics. If the person’s temperature is normal, the doctor does not look for an infection. If the person’s temperature is high (either for themselves or for the general population), it doesn’t mean there is an infection, but it will cause the doctor to consider the possibility. All of these vitals along with the person’s weight, height, and any significant physical changes are diagnostics. These are all things doctors check off. In finance, a firm’s ratios are its vital signs, and we use them as diagnostics for a firm.

7. In addition to using ratios as a diagnostic to check for problems within the firm’s operations, ratios are also used to predict the firm’s future performance. If, for example, COGS is repeatedly at 77% of sales, we assume it will remain at that percentage when we forecast the firm’s future performance.
8. Finally, we discussed the cash cycle. As noted above, the cash cycle represents one need/source of financing for a firm. Firms not only finance fixed assets, they must also finance net working capital (receivables plus inventory less accounts payable).

While we have covered a lot of material, in retrospect, we hope the progression of the questions we have asked and the tools we have used to answer them make sense. It is important, very important, to understand that financial analysis is as much of an art as a science. As with any art, the more you practice the more skilled you become. Returning to our doctor analogy, there are many reasons for a fever, and usually the more clinical experience a doctor has, the better she is at determining the reasons for your particular fever.