Question 7.10: Bounds and Context of Financial Measures The previous exampl......
Bounds and Context of Financial Measures
The previous example focused on the cash conversion cycle, which many companies identify as a key performance metric. The less positive the number of days in the cash conversion cycle, typically, the better it is considered to be. However, is this always true?
This example considers the following question: If a larger negative number of days in a cash conversion cycle is considered to be a desirable performance metric, does identifying a company with a large negative cash conversion cycle necessarily imply good performance?
Using the Compustat database, the company identified as the US computer technology company with the most negative number of days in its cash conversion cycle during the 2005 to 2009 period is National Datacomputer Inc. (OTC: NDCP), which had a negative cash conversion cycle of 275.5 days in 2008.
The reason for the negative cash conversion cycle is that the company’s accounts payable increased substantially over the period. An increase from approximately 66 days in 2005 to 295 days in 2008 to pay trade creditors is clearly a negative signal. In addition, the company’s inventories disappeared, most likely because the company did not have enough cash to purchase new inventory and was unable to get additional credit from its suppliers.
Of course, an analyst would have immediately noted the negative trends in these data, as well as additional data throughout the company’s financial statements. In its MD&A, the company clearly reports the risks as follows:
Because we have historically had losses and only a limited amount of cash has been generated from operations, we have funded our operating activities to date primarily from the sale of securities and from the sale of a product line in 2009. In order to continue to fund our operations, we may need to raise additional capital, through the sale of securities. We cannot be certain that any such financing will be available on acceptable terms, or at all. Moreover, additional equity financing, if available, would likely be dilutive to the holders of our common stock, and debt financing, if available, would likely involve restrictive covenants and a security interest in all or substantially all of our assets. If we fail to obtain acceptable financing when needed, we may not have sufficient resources to fund our normal operations which would have a material adverse effect on our business.
IF WE ARE UNABLE TO GENERATE ADEQUATE WORKING CAPITAL FROM OPERATIONS OR RAISE ADDITIONAL CAPITAL THERE IS SUBSTANTIAL DOUBT ABOUT THE COMPANY’S ABILITY TO CONTINUE AS A GOING CONCERN. (emphasis added by company)
Source: National Datacomputer Inc., 2009 Form 10-K, page 7.
In summary, it is always necessary to consider ratios within bounds of reasonability and to understand the reasons underlying changes in ratios. Ratios must not only be calculated but must also be interpreted by an analyst.
| EXHIBIT 13 National Datacomputer Inc. ($ millions) | ||||||
| Fiscal year | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 |
| Sales | 3.248 | 2.672 | 2.045 | 1.761 | 1.82 | 1.723 |
| Cost of goods sold | 1.919 | 1.491 | 0.898 | 1.201 | 1.316 | 1.228 |
| Receivables, Total | 0.281 | 0.139 | 0.099 | 0.076 | 0.115 | 0.045 |
| Inventories, Total | 0.194 | 0.176 | 0.010 | 0.002 | 0.000 | 0.000 |
| Accounts payable | 0.223 | 0.317 | 0.366 | 1.423 | 0.704 | 0.674 |
| DSO | 28.69 | 21.24 | 18.14 | 19.15 | 16.95 | |
| DOH | 45.29 | 37.80 | 1.82 | 0.28 | 0.00 | |
| Less: Number of days of payables* | 66.1 | 138.81 | 271.85 | 294.97 | 204.79 | |
| Equals: Cash conversion cycle | 7.88 | –79.77 | –251.89 | –275.54 | –187.84 | |
| * Notes: Calculated using Cost of goods sold as an approximation of purchases. Ending inventories 2008 and 2009 are reported as $0 million; therefore, inventory turnover for 2009 cannot be measured. However, given inventory and average sales per day, DOH in 2009 is 0.00. Source: Raw data from Compustat. Ratios calculated. |
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