Reading Financial Reports for Dummies (40 page)

$100

$100

$50

$450

Company

JK

$300

$150

$50

$50

$550

Company

Total

$800

$300

$150

$100

$1,350

Looking at the aging schedule, you can quickly see which companies are significantly past due in their payments. Many firms begin cutting off customers whose accounts are more than 60 or 90 days past due. Other firms cut off customers when they’re more than 120 days past due. No set accounting rule dictates when to cut off customers who haven’t paid their bills; this decision depends on the accounting policies the company sets.

In the aging schedule example for ABC Company, the JK Company looks like its account needs some investigating. Although a company can carry past-due payments because of a dispute about a bill, after that dispute goes beyond 90 days, the company awaiting payment may put restrictions on the other company’s future purchases until its account gets cleaned up. HI Company seems to be another slow-paying company that may need a call from the accounts receivable manager or collections department.

Many times, a company salesperson makes the first contact with the customer. If the salesperson is unsuccessful, the business initiates more severe collection methods, with the highest level being an outside collection agency.

Companies with strong collection practices place a gentle reminder call when an account is more than 30 days late and push harder as the account is more and more past due.

When a business decides that it probably will never collect on an account, it writes off the account as a bad debt in the Allowance for Bad Debt Account.

Each company sets its own policies about how quickly it writes off a bad debt. A company usually reviews its accounts for possible write-offs at the end of each accounting period. I talk more about accounts receivable and their impact on cash flow in Chapter 17.

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Finding the Accounts Payable Ratio

A company’s reputation for paying its bills is just as important as collecting from its own customers. If a company develops the reputation of being a slow payer, it can have a hard time buying on credit. The situation can get even more serious if a company is late paying on its loans. In that case, the business can end up with increased interest rates while its credit rating drops lower and lower. I discuss the importance of a good credit rating in Chapter 21.

You can test a company’s bill-paying record with the accounts payable turnover ratio. In addition, you can check how many days a company takes to pay its bills by using the days in accounts payable ratio. Keep reading to find out how to calculate these ratios.

Calculating the ratio

The
accounts payable turnover ratio
measures how quickly a company pays its bills. You calculate this ratio by dividing the cost of goods sold (you find this figure on the income statement) by the average accounts payable (you find the accounts payable figures on the balance sheet).

Here’s the formula for the accounts payable turnover ratio: Cost of goods sold ÷ Average accounts payable = Accounts payable turnover ratio

I use Mattel’s and Hasbro’s income statements and balance sheets for 2007 to compare their accounts payable turnover ratios.

Mattel

1. Find the average accounts payable:

$375,882,000 (2006 accounts payable) + $441,145,000 (2007 accounts payable) ÷ 2 = $408,513,500 (Average accounts payable)

2. Use that number to calculate Mattel’s accounts payable turnover
ratio:

$3,192,790,000 (Cost of goods sold) ÷ $408,513,500 (Average accounts payable) = 7.8 times

Mattel turns over its accounts payable 7.8 times per year.

Chapter 16: Examining Cash Inflow and Outflow

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Hasbro

1. Find the average accounts payable:

$160,015,000 (2006 accounts payable) + $186,202,000 (2007 accounts payable) ÷ 2 = $173,108,500 (Average accounts payable)

2. Calculate Hasbro’s accounts payable turnover ratio:
$1,576,621,000 (Cost of goods sold) ÷ $173,108,500 (Average accounts payable) = 9.1 times

Hasbro turns over its accounts payable 9.1 times per year, which is faster than Mattel.

What do the numbers mean?

The higher the accounts payable turnover ratio, the shorter the time between purchase and payment. A low turnover ratio may indicate that a company has a cash-flow problem.

Each industry has its own set of ratios. The only way to accurately judge how a company is doing paying its bills is to compare it with similar companies and the industry.

Determining the Number of Days

in Accounts Payable

The
number of days in accounts payable ratio
lets you see the average length of time a company takes to pay its bills. If a company is taking longer to pay its bills each year, or if it pays its bills over a longer time period than other companies in its industry, it may be having a cash-flow problem. Also, if a company pays its bills slower than other companies in the same industry, that could be a problem, too.

Calculating the ratio

Use the following formula to calculate the number of days in accounts payable: Average accounts payable ÷ Cost of goods sold × 360 days = Days in accounts payable

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Note:
The industry uses 360 days rather than a full year’s 365 to make this calculation based on an average 30-day month (30 × 12 = 360).

I use Mattel’s and Hasbro’s balance sheets and income statements to find the number of days in accounts payable ratio. I don’t have to calculate average accounts payable because I already did so when I calculated the accounts payable turnover ratio (see the section “Finding the Accounts Payable Ratio,”

earlier in this chapter).

Mattel

$408,513,500 (Average accounts payable) ÷ $3,192,790,000 (Cost of goods sold) × 360 = 46.1 days

Mattel takes about 46.1 days to pay its bills, or about 6.65 weeks, which is about 2 weeks less than it takes Mattel to collect from its customers — 8.4

weeks, as the accounts receivable turnover ratio shows. Therefore, Mattel is receiving cash from its customers at a slower rate than it’s paying out in cash to its vendors and suppliers. This could be a factor in the need for short-term borrowings of $349 million, as shown on the balance sheet.

Hasbro

$173,108,500 (Average accounts payable) ÷ $1,576,621,000 (Cost of goods sold) × 360 = 39.5 days

Hasbro takes about 39.5 days, or 5.71 weeks, to pay its bills. Hasbro’s accounts receivable turnover ratio shows that its customers take slightly more than 8.21 weeks to pay their bills. Therefore, Hasbro must pay its bills more quickly than its customers pay theirs, which could cause a cash-flow problem.

What do the numbers mean?

If the number of days a company takes to pay its bills increases from year to year, this may be a red flag indicating a possible cash-flow problem. To know for certain what’s happening, compare the company with similar companies and the industry averages.

Just as accounts receivable prepares an aging schedule for customer accounts, companies also prepare internal financial reports for accounts payable that show which companies they owe money, the amount they owe, and the number of days for which they’ve owed that amount.

Chapter 16: Examining Cash Inflow and Outflow

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Deciding Whether Discount Offers

Make Good Financial Sense

One common way that companies encourage their customers to pay early is to offer them a discount. When a discount is offered, a customer (in this case, the company that must pay the bill) may see a term such as “2/10 net 30” or

“3/10 net 60” at the top of its bill. “2/10 net 30” means that the customer can take a 2 percent discount if it pays the bill within 10 days; otherwise, it must pay the bill in full within 30 days. “3/10 net 60” means that if the customer pays the bill within 10 days, it can take a 3 percent discount; otherwise, it must pay the bill in full within 60 days.

Taking advantage of this discount saves customers money, but if a customer doesn’t have enough cash to take advantage of the discount, it needs to decide whether to use its credit line to do so. Comparing the interest saved by taking the discount with the interest a company must pay to borrow money to pay the bills early can help the company decide whether using credit to get the discount is a wise decision.

Calculating the annual interest rate

The formula for calculating the annual interest rate is:

[(% discount) ÷ (100 – % discount)] × (360 ÷ Number of days paid early) =

Annual interest rate

I calculate the interest rate based on the early-payment terms I stated earlier.

For terms of 2/10 net 30

You first must calculate the number of days that the company would be paying the bill early. In this case, it’s paying the bill in 10 days instead of 30, which means it’s paying the bill 20 days earlier than the terms require. Now calculate the interest rate, using the annual interest rate formula:

[2 (% discount) ÷ 98 (100 – 2)] × [360 ÷ 20 (Number of days paid early)] =

36.73%

That percentage is much higher than the interest rate the company may have to pay if it needs to use a credit line to meet cash-flow requirements, so taking advantage of the discount makes sense. For example, if a company has a bill for $100,000 and takes advantage of a 2 percent discount, it has to 226
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pay only $98,000, and it saves $2,000. Even if it must borrow the $98,000 at an annual rate of 10 percent, which would cost about $544 for 20 days, it still saves money.

For terms of 3/10 net 60

First, find the number of days the company would be paying the bill early. In this case, it’s paying the bill within 10 days, which means it’s paying 50 days earlier than the terms require. Next, calculate the interest rate, using this formula:

[3 (% discount) ÷ 97 (100 – 3)] × [360 ÷ 50 (Number of days paid early)] =

22.27%

Paying 50 days earlier gives the company an annual interest rate of 22.27 percent, which is likely higher than the interest rate it’d have to pay if it needed to use a credit line to meet cash-flow requirements. But the interest rate isn’t nearly as good as the terms of 2/10 net 30. A company with 3/10 net 60 terms will probably still choose to take the discount, as long as the cost of its credit lines carries an interest rate that’s lower than that available with these terms.

What do the numbers mean?

For most companies, taking advantage of these discounts makes sense as long as the annual interest rate calculated using this formula is higher than the one they must pay if they borrow money to pay the bill early. This becomes a big issue for companies because unless their inventory turns over very rapidly, 10 days probably isn’t enough time to sell all the inventory purchased before they must pay the bill early. Their cash wouldn’t come from sales but, more likely, from borrowing.

If cash flow is tight, a company has to borrow funds using its credit line to take advantage of the discount. For example, if the company buys $100,000

in goods to be sold at terms of 2/10 net 30, it can save $2,000 by paying within 10 days. If the company hasn’t sold all the goods, it has to borrow the $100,000 for 20 days, which wouldn’t be necessary if it didn’t try to take advantage of the discount. I assume that the annual interest on the company’s credit line is 9 percent. Does it make sense to borrow the money?

The company would need to pay the additional interest on the amount borrowed only for 20 additional days (because that’s the number of days the company must pay the bill early). Calculating the annual interest of 9 percent of $100,000 equals $9,000, or $25 per day. Borrowing that money would cost an additional $500 ($25 times 20 days). So even though the company must borrow the money to pay the bill early, the $2,000 discount would still save it $1,500 more than the $500 interest cost involved in borrowing the money.

Chapter 17

How Companies Keep

the Cash Flowing

In This Chapter

▶ Delaying bill payments to increase cash flow

▶ Collecting accounts receivable more quickly

▶ Using a receivables securitization program

▶ Ordering less inventory

▶ Finding quick cash

Managers sometimes face a shortage of cash to pay the bills, and they need to find ways to fix the problem. They can use different strategies to get their hands on cash quickly when running a business.

In this chapter, I review the pros and cons of the possible fixes available when a manager finds a red flag about a company’s cash flow.

Slowing Down Bill Payments

Short on cash? Well, maybe you can just let your bills slide. It may not be the most responsible policy, but sometimes doing so can get a company through a fiscal rough patch — as long as its suppliers are relatively patient.

When businesses buy on credit and don’t have to pay cash upon receipt of the goods, this is called
trade financing.
Often, businesses must pay for those goods within 30, 60, or 90 days. When cash gets tight, one of the first strategies many small-business owners (and even some large corporations) use is to pay their bills more slowly, and sometimes even pay them late, to make it through a cash crunch.

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This practice is known as
stretching accounts payable
or
riding the trade.
Some companies use this strategy as long as their suppliers and vendors toler-ate the late payments — in other words, until they threaten nondelivery of goods. The primary advantage of this plan is that the manager or business owner doesn’t need to look for a way to borrow additional money to pay operating expenses. The big disadvantage is that companies can build bad reputations among their suppliers and vendors and are less likely to get trade financing in the future.