Wednesday, June 18, 2008

Analytical Review 101 – Part XII

Day Payables Outstanding and the Cash Conversion Cycle

Day Payables Outstanding
In my earlier post, we discussed about the Trade Payables amounts. Trade Payables consists of amounts due to creditors and suppliers. It is noteworthy that the Trade Payables represents a source of financing to the company. Essentially, the company is purchasing goods or services from suppliers on credit, paying only after the credit period is due.

A indicator of the credit terms obtained by the company from its’ suppliers can be derived from the DPO ratio. Generally, this ratio indicates the length of time taken by the company to pay its’ trade payables. This ratio will vary from industry to industry. As such, it is more useful to compare this ratio over a period of time or against other companies’ in the same industry.

A high DPO ratio (e.g. in excess of 90 days) is considered favorable as the company is obtaining excellent credit terms and financing from its’ trade creditors. However, it is important to note the trend of the DPO ratio. If the Trade Payables amount and DPO ratio has increased significantly within a short period, it may indicate that the company is facing cash flow problems and is unable to pay its’ trade creditors on time. This can be corroborated by reviewing the cash flow statements and other liquidity ratios as discussed earlier.

Cash Conversion Cycle (CCC)
The CCC ratio attempts to quantify the time taken by the company to convert its’ inventories into cash, after accounting for the credit period (i.e. financing) provided by its’ trade creditors. The CCC ratio is significant as it indicates the efficiency of the company in converting inventories into cash. The lower the ratio, the faster the company is the rate of conversion of company’s inventories into cash. Conversely, a high ratio indicates that the company may be facing problems in collecting debts from its’ customers or have non-saleable stocks. This would contribute to the delay in converting its' inventories or receivables into cash.

This ratio will vary widely based on the industry the company is in. A company with a long gestation period such as construction companies’ will have a long CCC ratio whereas one in the FMCG industry should have a relatively low CCC ratio. Comparing this ratio over a period of time or companies in the same industry will provide a clearer picture of the effectiveness of management in generating operating cash flows.

Analytical Review
An investigation of Nestlé’s financial statements reveals that its’ DPO ratio is 49.46 days (2006: 42.68 days). This means that Nestlé has either obtained more favorable credit terms from its’ suppliers or is successful in delaying payments to its’ trade creditors. This modest increase of 15.9%, divulges the fact that Nestlé may be delaying payment to its’ trade creditors’ as most of its' cash are tied up in its’ inventories. A review of its’ operating cash flows discloses that the company is on sound financial footing and does not have problems in paying its’ trade creditors on time, if necessary. Overall the DPO ratio is generally favorable.

The CCC ratio has increased by 11.3% from 45.28 days in 2006 to 50.41 days currently. This increase indicates that Nestlé's efficiency in converting its’ inventories into cash, has decreased. Further investigation exposes the fact that there is a disproportionate increase in inventories (35%) compared to the increase in revenue (4.29%). This is the main contributor to the increase in the CCC ratio and the reduction in operating cash flows by 18.82% to RM291MIL compared to RM358MIL in 2006.

The DPO and CCC ratio reveals that Nestlé is less efficient in converting its’ inventories into cash. Still, the CCC ratio and operating cash flows are still reasonable, even though it is less impressive, when compared to 2006. We have completed our review of the liquidity ratios and cash flow movements of the company. Next, we shall look at the Debt Ratios and Nestlé's solvency.


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