Monday, June 30, 2008

Romance of the Three Kingdoms – Part VIII


The Battle of Red Cliff, End Game: 連環計 Symphony of Stratagems

Three Rulers vying for supremacy,
Three Factions struggling for survival,
Three Stratagems forged in concert,
Threads of destinies, woven together,
Thus, was laid the foundation of the Three Kingdoms.

In 208 AD during the Northern Winter, Cao Cao led his army numbering 240,000 against Southern China. Fresh from the euphoria of a highly successful Northern Campaign, vanquishing enemies such as Lu Bu, Yuan Shao, Yuan Shu and Liu Biao, the Imperial Chancellor of Han seemed unstoppable.

The southern Alliance of Sun Quan and Liu Bei had a mere 50,000 marines at their disposal. Being outnumbered numerically almost 5 to 1, many counseled the Alliance to formally surrender to Emperor Xian and Cao Cao, the Imperial Chancellor of Han. However, warlords Liu Bei and Sun Quan were adamant in opposing Cao Cao. The final line of defense for the Alliance was the Yangtze River.

The Decisive Encounter
After the initial skirmishes, the final decisive encounter between the two forces would take place on the Wulin battlefields on the northwestern bank of the Yangtze. During this pivotal encounter, the commander of the Alliance’s Forces, Maestro Zhou Yu unleashed his 連環計 Symphony of Stratagems on Cao Cao’s massive fleet.

1. Alpha Stratagem: 苦肉計 Gain a rival’s trust through self-mutilation
At the Wulin battlefields, Cao Cao’s gargantuan fleet was positioned at the northern banks. Zhou Yu waited patiently; biding his time until the southeastern wind was blowing strongly. He then instructed Huang Gai to send a messenger to Cao Cao bearing the message below:

"Zhou Yu has kept such strict watch that there has been no chance of escape. But now some grain is coming down river, and I, Huang Gai, have been named as escort commander which will give me the opportunity I desire. I will slay one of the known generals and bring his head as an offering when I come. This evening at the third watch, if boats are seen with dragon toothed flags, they will be the grain boats."

Cao Cao’s was delighted at Huang Gai’s purported defection and relaxed his guard. Shortly thereafter, Huang Gai prepared a squadron
of capital ships described as mengchong doujian 蒙衝鬥艦. These ships had been converted into fire ships by filling them with bundles of kindling, dry reeds, and fatty oil. As Huang Gai's "defecting" squadron approached the midpoint of the river, the sailors applied fire to the ships and escaped to small boats. The unmanned fire ships, carried by the southeastern wind, sped towards Cao Cao's fleet and set it ablaze.

2. Zeta Stratagem: 借刀殺人 Yin overwhelms Yang
Despite the strategic acumen displayed by Cao Cao in his Northern Campaign, he was led astray by the beguiling words of Young Phoenix. Cao Cao was so enamored with the idea of removing the seasickness from his army and re-establishing his infantry and cavalry’s fighting prowess that he was oblivious to the risk of a fire attack by the Alliance.

Since Cao Cao’s immense navy was gathered tightly and chained firmly together, it was impossible for his ships to scatter and flee from the fire. Following the initial shock, Zhou Yu and the allies led a lightly armed force to capitalize on the assault. Within a short time smoke and flames stretched across the sky and a large number of men and horses either burned to death or drowned. The northern army was thrown into confusion and was utterly smashed. Seeing the situation was hopeless, Cao Cao then issued a general order of retreat and destroyed a number of his remaining ships before withdrawing

3. Omega Stratagem: 關門捉賊 Encircle and Capture
Cao Cao’s retreat towards Jiangling was beset with numerous setbacks as Zhuge Liang had divined Cao Cao’s exact line of retreat, based on his understanding of Cao Cao’s psychological make up. The numerous ambushes and attacks on Cao Cao’s forces during their retreat towards the city of Jiangling decimated the remnants of his army.

Due to his extremely suspicious nature, Cao Cao was misled into leading his men towards the Huarong Trail, where Guan Yu and his men lay waiting. Cao Cao’s forces was ambushed by Guan Yu. They were in a pitiful state and were in no condition to resist Guan Yu. The Symphony of Stratagems was concluded.

人算不如天算 Man Proposes: God Disposes
Guan Yu's success in capturing Cao Cao, would have led to the eventual demise of the Northern Wei kingdom. Even though there were numerous capable leaders in Wei, these generals were loyal only to Cao Cao. His capture or death would lead to the Wei Kingdom disintegrating into various factions, since Cao Cao had no apprarent heir at this point in time.

Unfortunately for the Alliance, Guan Yu had been captured by Cao Cao in the past. At that time, he had agreed to serve Cao Cao, subject to three conditions: that his surrender was to the Han emperor and not Cao Cao; that the two wives of Liu Bei were to be suitably provided for and protected; and that all three would leave to seek Liu Bei once they found out his whereabouts. These conditions were agreed to and Guan Yu surrendered without breaking the code of loyalty. Guan Yu had subsequently left Cao Cao, upon discovering the whereabouts of Liu Bei.

Guan Yu, being the paragon of virtue,could not forget the great kindness he had received at Cao Cao's hands, and the magnanimity Cao Cao had shown to him in the past. He saw the desperate straits to which his benefactor was reduced, and tears were very near to the eyes of both. He could not press Cao Cao hard and was moved to release him. Thus, the proverb: 人算不如天算 Man Proposes: God Disposes.

By the end of AD209, the Cao Cao’s fort established at Jiangling fell to Zhou Yu. The borders of the land under Cao Cao's control contracted about to the area around Xiangyang. Liu Bei, on the other hand, had gained territory by taking over the four commanderies south of the Yangtze River. Never again would Cao Cao command so large a fleet as he had at Jiangling, nor would a similar opportunity to destroy his southern rivals present itself again. The Battle of Red Cliff and the capture of Jing province by Liu Bei confirmed the separation of Southern China from the northern heartland of the Yellow River valley, and also foreshadowed a north-south axis of hostility which would resonate for centuries (de Crespigny).

Friday, June 27, 2008

Speed Reading - Part II


Before we begin, let me clear some misconceptions that arise due from the term 'Speed Reading'. Speed Reading is NOT about:

1. Pushing your eyeballs to the maximum, to scan reading materials;
2. Reading as fast as possible, all manner of materials, causing you to lose the pleasure of reading certain materials such as novels and poems; or
3. Teaching you on how to obtain a photographic memory.

For me, speed reading is just about reading at an appropriate speed, which depends largely on the TYPE of reading material and the WHY you are reading it. It is designed to help you comprehend better and faster. Although this sounds oxymoronic, this can actually occur because most of us have bad reading habits, simply because no one taught us how to read properly.

However, before we begin on this journey – let us begin by understanding the four levels of reading. The information presented below are largely based on the book ‘How to Read a Book by Mortimer J. Adler and Charles Van Doren.

The differences between the levels must be understood so that we are able to improve our reading skills. Each level of reading must be understood before one can move on to the next level. This is because each level of reading is cumulative and forms the foundation to achieve the next level, forming a pyramid shape as indicated in the diagram above.

First Level – Elementary Reading
To master this level, one must learn the rudimentary art of reading by receiving basic training and acquiring initial reading skills. This is ordinarily learned during primary school. I am certain all of us have achieved this level. Yet, even for those who have attained this level, some may have picked up certain undesirable habits such as sub-vocalizing, fixations and regressions. To read about Common Problems in Elementary reading, click here: Part I & Part II.

Second Level – Inspectional Reading
This level of reading is characterized by its special emphasis on time. At this stage, a student might be allowed a set time, to complete a certain amount of reading. Inspectional reading is the art of skimming systematically the material. Here, one attempts the best and complete reading that is possible given a LIMITED amount of time. For more information about Inspectional Reading, please refer to the following Inspectional Reading: Systematic Skimming and Inspectional Reading: Superficial Reading.

Third Level – Analytical Reading
At this stage, reading is a complex and systematic activity. This requires a thorough and complete reading. Unlike inspectional reading, analytical reading attempts the best and complete reading, given an UNLIMITED amount of time. The reader here, must ask many and organized questions. Since this is an intense activity, it is NOT REQUIRED for all reading. It is used only when you require an in-depth understanding of the particular book you are reading. For a bird's eye view of Analytical Reading, please click here.

Fourth Level – Syntopical Reading
The most complex and systematic type of reading, also requires the highest skill level. The reader must read many books and place them in relation to one another and to the subject at hand. Not only must he compare and contrast between these books, he needs to do much more! He must SYNTHESIZE the materials he has read, and reach observations and conclusions, that are not available in any of the books he has read.

With an overview of the four levels of reading, we can now explore them in subsequent posts. We shall identify, how best to improve our reading techniques, systematically at each level.

Wednesday, June 25, 2008

Analytical Review 101 – Part XIV

Money Talks, Bullshit Walks: You and Mr. Market

Ultimately, as Intelligent Investors, we are only concerned about one thing. What is the value of the shares we are buying, truly worth? Based on our analysis, if we feel the company is worth between a range of RM30-35 per share and it is currently trading at RM25, then it worthwhile to purchase the shares in the company. Eventually, the market will price the Company's shares according to its’ underlying value.

Consequently, before investing, it is important to carry out an analysis backed up by financial data, rather than relying on speculation and market rumors. In future posts, we shall see how to use these historical data in conjunction with the market data to assess whether investing in a company is worthwhile.

Sources of Market Data
The Business Week website gives you free access to the market price and volumes traded, of major companies’. Most of the market price and trading volume, of major listed companies are free available on the Internet, so just Google for such information.

The link to view the share price of Nestle is here:

The Real Deal: Share Price
Up to now, we have been analyzing historical information based on the annual audited financial statements. Such historical information furnishes us the track record of management's ability to generate returns for its’ investors. However, we are missing a vital link: the Share Price!

The Share Price of a Company on a particular day represents the last transacted price between a willing buyer and willing seller. For an Intelligent Investor, the Share Price of a company DOES NOT represents the worth of a Company.

WHAT! WHAT [insert expletive here] ARE YOU TALKING ABOUT?

Mr. Market
Well, the reason is very simple. Markets are IRRATIONAL! I shall let Warren Buffett explain further on this concept. This is extracted from one of his letters to the shareholders of Berkshire Hathaway.

Ben Graham
Ben Graham taught me that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. The true investor welcomes volatility. Ben Graham explained this in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

The Risk
Sometimes, the share price of a company (say ZGL) appears to be trading at a large discount from their underlying values. In reality, say that this is not the case. Mr. Market has correctly priced the shares due to business risks and other factors that you had overlooked. Here, you may have bought the shares at RM25 as your (erroneous) analysis, indicates that the underlying value should be around RM30-35 per share.

During this period, the share price of ZGL has plunged from RM25 to RM10 in the span of one year. Do you still keep your shares in ZGL in the belief that Mr. Market has incorrectly priced its’ shares? Or do you dump all your shares in ZGL and sell out?

As an Investor, you have to rely on something important called JUDGEMENT. Not even the world’s greatest investor, Warren Buffett is perfect. Expect to make some missteps, when joining the world of investing. The best thing to do is to set your tolerance level for losses. You may set a trigger point to sell ZGL shares, if it falls below a certain value. This is important as most of us are reluctant to admit when we have made a bad call. It is not easy to cut your losses but you must do so! Don’t throw good money after bad!

For instance, you could set your trigger point to sell ZGL shares if it falls by 40% from your initial purchase price (i.e. the market price of ZGL's shares drops to RM15 per share). Even though you have lost 40%, at least you preserved the remaining 60% of your capital. Obviously if the shares price shoots up to RM40 a year later, then the fact you were RIGHT, would be of cold comfort.

We have looked at how to obtain the current share price of our target company. In addition, we have briefly explored the key investment strategy of an Intelligent (or Value) Investor. Please also keep in mind, Warren Buffett's illuminating explanation on the concept of Mr. Market, and how one can profit from market foibles and irrationalities . In my future posts, we shall use the share price of the company in conjunction with historical data, to assess the underlying value of a company.

Monday, June 23, 2008

Romance of the Three Kingdoms – Part VII


The Battle of Red Cliff, Final Link: 關門捉賊 Encircle and Capture

With the first two stratagems chained, the stage was set for a potentially explosive battle between the two forces. The Alliance were confident of Cao Cao’s eventual defeat as he had fallen prey to their earlier stratagems. Yet, the Alliance led by Zhou Yu and aided by Zhuge Liang had the foresight to realize that, even if Cao Cao suffered massive losses and casualties at the Battle of Red Cliffs, he would still post a huge threat the Alliance at a later date, if he managed to escape. Cao Cao’s northern empire was immense and he had numerous reserve infantry and cavalry at his disposal.

Armed with such foresight, the Alliance forged the final link in the Symphony of Stratagems: 關門捉賊 Encircle and Capture Stratagem. This stratagem was to be employed at the End Game. If Cao Cao suffered a decisive loss, his most obvious line of retreat would be to escape northwards towards the city of Jiangling.

Foreseeing this, Zhuge Liang had dispatched several of Shu’s best generals including Zhao Yun, Zhang Fei, Liu Qi and Guan Yu stationed at various paths along the route northwards to Jiangling. Zhuge Liang was able to foreshadow Cao Cao’s exact line of retreat, based on his understanding of Cao Cao’s frame of mind.

Based on Zhuge Liang’s calculations, numerous ambushes were placed along the route northwards, intended to whittle down Cao Cao's forces, leading to his eventual capture. Under Zhuge Liang’s instructions, Guan Yu prepared an ambush by stationing 500 men along the Huarong Trail, a narrow shortcut in the woods leading towards Jiangling. Guan Yu was directed to also set off columns of smoke along the Huarong Trail.

If Cao Cao was defeated at the Battle of Red Cliff, his eventual retreat northwards would lead him across two possible paths towards Jiangling:

1. A high road, more level but fifteen miles longer; or
2. A shorter by-road leading towards Huarong Valley. This road was narrow and dangerous, full of pits and difficult to traverse. In short, an ambush could easily be set along the Huarong Trail.

Cao Cao’s scouts reported that there were columns of smoke rising from the hills along the Huarong Valley. Zhuge Liang’s complete understanding of Cao Cao’s psychological make-up was evident in his directions to Guan Yu.

Due to his extremely suspicious nature, Cao Cao was likely to be misled into concluding that the smoke was a trick of the enemy to divert him to the main road, where an ambush must have been laid. He would then decide to lead his men towards the narrower path, the Huarong Trail, where Guan Yu and his men lay waiting. The remnants of his forces, likely to be tired from being constantly attacked would be in no condition to resist Guan Yu's ambush. Cao Cao’s fate would now lay in the hands of Guan Yu.

If the Symphony of Stratagems were correctly chained and executed, not only would the Alliance win a resounding victory at the Battle of Red Cliff but they would successfully eliminate the primary antagonist facing the Alliance. Would the Alliance’s chain stratagems work? Watch out for my next post.

Friday, June 20, 2008

Analytical Review 101 – Part XIII


It has been stressed that cash is of primary importance for a company. Without cash, the company would not be able to function, even if it is making substantial amount of paper profits. In order to measure whether the company has sufficient cash reserves or able to convert its’ assets into cash to meet its’ obligation, there are two financial terms that we must be conversant with.

Liquidity refers to the ability of the company to meet its’ short term obligations and commitments (i.e. those liabilities due within a year from the Balance Sheet date). The liquidity ratios discussed earlier, gives an indicator of the how relatively liquid a company is.

Solvency is a gauge of the company’s ability to meet its’ long term liabilities (i.e. commitments exceeding a period of one year from the Balance Sheet date). The Debt Ratios' above are intended to reveal whether the Company is able to meet its’ long term liabilities in the long term. When we say a company is solvent, this means that the Company should be able to repay all its’ long term loans and borrowings and other commitments, in the future, usually due to its’ large assets base and ability to generate favorable operating cash flows.

Effective Interest ratio
We have computed the Effective Interest ratio in Part X. Briefly, the effective interest rate ratio gives an indication of the interest rates incurred by the Company on its’ loans and borrowings. Low interest rates on loans and borrowings, are beneficial to the shareholders as the shareholders will pocket the excess between:

1. The returns generated by the Company using these loans and borrowings; and
2. The interest costs associated to these loans and borrowings.

This concept is also referred to as gearing. There is an additional benefit in that, interest expenses are tax deductible and will reduce tax liabilities due to the Inland Revenue.

Operating Cash to Interest (OCI) ratio
The OCI ratio is crucial as it gauges whether the company can generate sufficient cash from its’ operations to service interest payments on its’ loans and borrowings.

An high OCI ratio (e.g. in excess of 10x) is favorable as this reveals the Company can service its’ debts with ease. If the OCI ratio is 1.5x or lower, its ability to meet interest expenses may be questionable. Once the OCI ratio falls below 1.0x, alarm bells should start ringing, since the Company's operating cash flows are insufficient to service interest payments. What about the repayment of the principal amount?

Debt Service Coverage (DSC) ratio
Whereas the OCI ratio compares the Operating Cash Flows to the Interest Costs, the DSC ratio compares the Net Profit for the Year against the Interest Costs. In effect, we are comparing the book profits against the interest expense. Generally, the higher the ratio, the more favorable it is. The general consensus is that the Company can service its’ interest costs and repay its' loans, if the ratio is 1.35x or more. However, this will vary from industry to industry and care must be taken when attempting to interpret this ratio.

Analytical Review
The effective interest ratio appears favorable to Nestlé as it is paying a very low interest of 4.82% (2006: 5.80%) on its’ loans and borrowings. The company’s abilities to obtain such favorable rates is partly due to its’ healthy operating cash flows and strong credit rating.

Analysis of the OCI ratio discloses that there has been deterioration in this ratio by 44.83% to 19.58x (2006: 35.49x). This is mainly due large amounts of cash tied up in inventories as at year end. However, a ratio of 19.58x indicates that that Nestlé should have no problems whatsoever, to service interest on its’ loans and borrowings.

A review of the DSC ratio indicates that this amount has also declined to 19.68x (2006: 26.19x). Still, this indicates that Nestlé is still highly profitable. The profits generated by the Company are more than sufficient (i.e. 20x) to repay interest expenses incurred. This is in line with the OCI ratio.

Generally, Nestlé appears to be liquid and solvent. All indicators suggest that the Company has strong operating cash flows, sufficient to service its' interest costs. Despite the large loans and borrowings due in 2008, there are strong assurances that the Company would be able to refinance such loans and borrowings, for reasons outlined earlier.

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.

Monday, June 16, 2008

Romance of the Three Kingdoms - Part VI


The Battle of Red Cliff, Successive Subterfuge: 借刀殺人 Yin overwhelms Yang

The Alliance had successfully deployed the 苦肉計 earlier. The time had come for the Alliance to now to chain this to the 借刀殺人 stratagem. A literal translation of this ruse is Kill with a borrowed knife. In my opinion, this stratagem is better described as the Yin overwhelms Yang ruse. When the situation is not favorable, one should not meet the enemy head on. Instead, one should seek to use the strength of another, or even the enemy’s own strength, against him.

With Cao Cao’s naval base established, daily drills were carried out to convert his vast infantry and cavalry, into a marine corps. It would only be matter of time before this vast army was ready to meet the Alliance in a decisive naval battle.

How could the Alliance defeat Cao Cao’s army? A successful defense would require an ingenious use of the 借刀殺人 stratagem, using Cao Cao’s own strength against him. Clearly, the strength of Cao Cao’s army lied with their extensive experience in land warfare. Their weakness was equally apparent; the alien surroundings, unfamiliarity with naval warfare and seasickness suffered by his troops.

If Cao Cao were presented with a plan that would eliminate his army’s seasickness and play to his strengths, could he refuse? With such a plan and his overwhelming numerical superiority, his army’s strength would be irresistible!

A person of immense intellect and cunning would have to be sent to convince Cao Cao fall prey to this stratagem employed by the Alliance. Young Phoenix: Pang Tong, currently serving the warlord Sun Quan, was sent to achieve this difficult task.

Through an intermediary, Pang Tong agreed to defect from the Alliance and was formally introduced to Cao Cao. They discussed military matters, and Pang Tong held forth at length. Remarks and comments flowed freely between the two, and Cao Cao formed an exalted opinion of his new adherent's abilities and treated him with the greatest honor.

Pang Tong then suggested the following to Cao Cao to rid his men of seasickness during the upcoming decisive naval encounter with the Alliance:

"The river is wide, and the tides ebb and flow. The winds and waves are never at rest. Your troops from the north are unused to ships, and the motion makes them ill. If your ships, large and small, were classed and divided into thirties, or fifties, and joined up stem to stem by iron chains and boards spread across them, to say nothing of soldiers being able to pass from one to the next, even horses could move about on them. If this were done, then there would be no fear of the wind and the waves and the rising and falling tides."

How could Cao Cao resist this alluring plan? 借刀殺人 stratagem was employed by Pang Tong to perfection. Ostensibly, this plan would play to Cao Cao strengths and allow him to defeat the Alliance. Yet, this scheme would also render Cao Cao’s naval army to be dreadfully susceptible to a fire attack. Cao Cao was so enamored by the allure of removing the seasickness from his army that he threw caution to the wind and embraced Pang Tong’s plan.

The Alliance has successfully chained the 苦肉計 stratagem to the 借刀殺人 ruse. If the final stratagem was successfully employed, the stage would be set for an overwhelming victory for an Alliance. Would Cao Cao fall under the spell of the Symphony of Stratagems strung by Maestro Zhou Yu? We shall see.

Friday, June 13, 2008

Analytical Review 101 – Part XI


Earlier on, we reviewed the Current Assets and Liabilities section of the Balance Sheet in detail.

Current Assets are generally cash or assets that the company should be able to convert into cash within the period of one year.

Similarly, Current Liabilities are obligations or commitments that must be settled by the company within a year.

As Current Assets and Current Liabilities are assets and liabilities, receivable or due within a period of one year respectively, it is appropriate to compare these two amounts as an indicator of the company’s liquidity.

Current Ratio
The current ratio (as computed above), compares the current assets of a company against its’ liabilities. Generally, the higher the ratio, the more liquid the company is. If the current ratio is equal to 2.0x or more, the company is considered generally liquid, i.e. it should not have problems in meeting its’ short term obligations. If this ratio is less than 1.0x, then the company may have troubles to meet its' short term commitments. However, these are mere guidelines. The ratio may vary from industry to industry and care must be taken when interpreting this ratio.

Even when the current ratio is 2.0x or higher, it is important to analyze the components of the current assets. If the trade receivables or inventories are abnormally large, compared to previous years, then the DSO or Inventory Turn ratios' may raise alarms concerning the recoverability of the trade receivables or possibility of overstocking, respectively. If this is the case, although the current ratio is favorable, the company may still face liquidity issues due to problems in collecting debts or selling its’ inventories.

Quick Ratio
Generally, current assets indicate cash balances and those assets that are easily convertible to cash within a span of one year. If one wishes to be conservative, it may be better to exclude inventories from the current assets. This is because inventories may not be easily saleable, especially during a difficult economic climate.

The quick ratio compares HIGHLY LIQUID CURRENT ASSETS (i.e. Current Assets excluding Inventories) to the current liabilities. By and large, a ratio of 1.0x or higher, signifies that the company has good liquidity. This is because it can convert its’ HIGHLY LIQUID CURRENT ASSETS into cash to meet its’ short term commitments and obligations. Conversely, a quick ratio of less than 1.0x, indicates that the company may have issues in fulfilling its’ short term obligations. Take note that the figures are merely for guidance and may vary from industry to industry. Exercise care when interpreting the quick and current ratios.

Even if the quick ratio is 1.0x or higher, liquidity problems could still arise. If the company is facing troubles collecting amounts due from its customers, it will be reflected in large trade receivables balance and DSO ratio. In such a case, a quick ratio of 1.0x or more, may be meaningless as the company is unable to convert its’ trade receivables into cash to pay its’ short term commitments.

Analytical Review
An analysis of Nestlé’s Current Ratio indicates it is hovering around 1.08x (2006: 1.20X). This lower current ratio is mainly due to the large amounts of loans and borrowings due within one year from the Balance Sheet date of 31 December 2007. This signifies that if Nestlé can convert all these current assets to cash, it would be able to repay all its’ commitments. Generally this is acceptable, especially considering that the banks would have no problems in refinancing these loans and borrowings due to Nestlé’s strong operating cash flows.

The Quick Ratio of 0.57x (2006:0.71x) implies that most of the company’s current assets are inventories. However, as Nestlé’s is in the Fast Moving Consumer Goods (FMCG) industry, it should have little problems in selling its’ inventories and converting these into cash. The lower ratio is not worrying as an analysis of the DSO and Inventory Turn ratio suggests that trade receivables are still being collecting promptly and there is only a moderate decrease in the turnover of inventories. Overall, operating cash flows are still significantly large to enable Nestlé to meet its’ short term commitments.

The Current and Quick Ratios' are convenient ratios to gauge the liquidity of a company. However, always keep in mind that a Current Ratio and Quick Ratio value of 2.0x and 1.0x respectively, does not necessarily mean the company is liquid. Further analysis of the DSO and Inventory Turn Ratio is required. This is to ensure that the favorable Current and Quick Ratios' are not due to mounting Trade Receivables and Inventories, arising from debt collection problems or non-saleable stocks.

Wednesday, June 11, 2008

Analytical Review 101 – Part X


Financing Company's Operations
To set-up a company, the shareholders need to initially pump in cash to finance the operations of the company. This is usually represented by the share capital.

Why Borrow?
Even though the operations of the company may be highly profitable, sometimes the shareholders are unable to expand as they have insufficient cash to finance costly expansions such as building new factories or investing in more sophisticated machineries or R&D. To finance such expansions, companies often borrow from banks or leasing companies.

Borrowings from banks usually come in the form of loans. If the company is small one, some form of security is required, either on the assets of the company such as land & buildings or personal guarantees from directors of the company. For large companies with excellent credit ratings, the banks may offer an unsecured loan.

Finance Lease Liabilities
Financing from leasing companies are in the form of purchase of large assets such as plant and machineries. The leasing companies will pay the suppliers of such machineries. The company will then undertake to pay the leasing companies a fixed monthly lease payment over a period of time. The total monthly lease payments will exceed the purchase price of the plant and machineries. These lease commitments are recognized in the Balance Sheet as Finance Lease Liabilities.

Operating Cash Flows
Banks and leasing companies are not charities. They expect the company to repay the monthly installment payments comprising of the principal and interest on a timely basis. A company that has loans and borrowings, must generate sufficient positive operating cash flows to finance the monthly installment payments. The Operating Cash to Loans and Borrowings Ratio (OCLB) indicates the financial ability of the company to repay such loans. A ratio higher than 1.5 is a positive indicator of the company’s abilities to service its’ loans and borrowings.

Interest Rates and Gearing
A benefit of loans and borrowings is that the interest’ rates charged by banks and leasing companies are usually lower than the profits generated by companies.

For example, if the company can generate profits of 15% on every Ringit invested in the Company, whereas the effective interest on loans is only approximately 5%, it may be desirable to borrow money to finance expansions. Why? Instead of raising additional share capital from its’ shareholders, the company can borrow from the banks instead. The banks are only entitled to a 5% return on its’ loans. The shareholders will be entitled to pocket the excess 10% difference (15% profit – 5% interest).

The effective interest rates on loans and borrowings can be computed as indicated above. When the company is generating a return that is substantially in excess of the effective interest rates, this is reasonably good as the shareholders will enjoy a higher return at the expense of the banks and leasing companies. Further, the interest payments to the banks or leasing companies are tax deductible, which will further reduce the company's tax expense.

In financial terms, this benefit is known as gearing or leverage.

The Dangers
Often companies tend to leverage their Balance Sheets excessively. Whilst using Other People’s Money (OPM) is an enticing idea, there are dangers if taken to the extreme. These include:

1. Downturn in economy or industry
When there is an unexpected downturn in the economy or the industry, the company’s operating cash flows will quickly dry up. Without sufficient operating cash flows, the company must resort to using its’ cash balances to repay the banks and leasing companies. If the company is unable to manage its’ cash flows well or refinance its’ loans, it may fail to service its’ debts. This may result in the banks or leasing companies foreclose on the loans and file a bankruptcy suit against the company.

2. Non-viable Business Model
If a company is perpetually refinancing its’ loans with and the quantum of loans and borrowings on its’ Balance Sheet is ballooning, this may indicate that the business model is not a viable one. Remember, a company’s PRIMARY PURPOSE is to generate PROFITS and convert them into CASH! When a company is unable to generate sufficient operating cash flows to repay its' loans and borrowings over the long term, you must ask yourself this:

IF NOT NOW (the company can't repay its' loans after a no. of years), THEN WHEN (can the company generate sufficient cash to do so)?

Analytical Review
A cursory review of the effective interest rates indicates that Nestlé is managing to keep its’ borrowings costs extremely low. An effective interest rate of only 4.70% (2006: 5.80%) is extremely favorable as the current FD rates per annum are approximately 3.70%. Further, all the borrowings of the company is unsecured which reflects the company has excellent credit ratings.

The OCLB ratio is 2.52x (2006: 1.35x) reflecting that Nestlé will have little trouble servicing its’ debts. Overall, with such strong operating cash flows, the burning question is WHY BORROW in the first place?

There may be two main reasons for this. Firstly, Nestlé wishes to leverage its’ Balance Sheets to generate higher returns for its’ shareholders. Secondly, it may be using these borrowings to maintain its’ aggressive dividend payout policy to maintain its’ share prices.

Even though RM308MIL of loans and borrowings are due in 2009, Nestlé strong operating cash flows and excellent credit rating, means the company will no problems in refinancing such loans.

Despite having huge loans and borrowings of RM308MIL and amounts due to related companies of RM129MIL, Nestlé is financially stable. Its’ operating cash flows are sufficient to enable it to repay these borrowings in the long term.

Tuesday, June 10, 2008

Analytical Review 101 – Part IX

Balance Sheet – Current Liabilities

What is a Balance Sheet?
The Balance Sheet shows the position of the company as at the end of the financial year (or as at a specific date). The Balance Sheet contains summary information of all assets and liabilities of the company including its' Intangible Assets, Property, Plant and Equipment, Long Term and Current Assets, Long Term and Current Liabilities and the Shareholders’ Equity. This is noteworthy as it gives us an indicator as to the value or worth of a company.

What do Current Liabilities represent?
These are liabilities or obligations of the business that must be paid in cash within a period of one year. It usually consists of trade payables, other payables, loans and borrowings and taxation, that are due within a period of 12 months from the balance sheet date.

1. Trade Payables
Trade Payables consists of amounts due to creditors and suppliers. These amounts arise because most long term suppliers would give credit terms to the company. The average credit period given by the supplier would depend on, inter-alia, the relationship between the company and its’ suppliers and the type of goods sold or services rendered by its’ suppliers.

The longer the credit period given by the suppliers to the company, the larger the trade payables amounts recorded in the Balance Sheet. Why would suppliers grant credit periods to the company? Wouldn’t it be better for the suppliers impose Cash on Delivery (COD) terms on all purchases by the company?

Purchases by a company are usually on credit terms because most companies expect to be given credit terms as a gesture of trust and goodwill. Companies usually try to negotiate and obtain favorable credit terms from its’ long term suppliers so as to conserve its’ cash flows.

A sudden increase in trade payables of a company as compared to previous years, is not always favorable. True, the company is conserving its’ cash flows by paying its’ trade creditors later. However, this may be an indication that the company is facing cash flow problems and is UNABLE to pay its’ creditors on time. Another possibility is that the company’s operating cash flows may be used to pay off other more critical obligations such as repayment of loans to banks.

2. Other Payables
These usually consists of:
(a) Amounts due to related companies (trade and non-trade); and
(b) Other payables;
(c) Accrued Expenses.

By and large, this figure is stable and does not change significantly over the long run. It is usually not significant in the evaluation of the company’s value.

However, in Nestlé’s case, it is significant to note that the company owes its’ related companies approximately RM129MIL. Approximately 33.50% of these debts are trade related whereas the balances of 66.50% are non trade. A review of the cash balances of Nestlé’ reveals a balance of only RM31.6MIL. If these related companies were to require immediate repayment, the company would have insufficient cash to repay these obligations.

This further indicates that Nestlé may be pursuing an overly aggressive dividend payout policy and financing this partly through inter-company payables. Approximately 39% of these inter-company payables (i.e. RM50.15MIL) is a short-term loan denominated, in Japanese Yen and interest bearing at 3.72% per annum. The balances of RM78.85MIL are unsecured, repayable on demand and interest-free.

The above facts indicates Nestlé dividend policy may not be sustainable in the long run. The company must conserve its’ cash flows, if it is to repay its' mounting of debts and obligations. However, it is pleasing to note that the inter-company payables have been halved in 2007 as compared to 2006.

3. Loans and borrowings
For a company with such strong operating cash flows, it is disconcerting to note that the company’s short term loans and borrowings have ballooned almost fourfold in 2007. The company’s short term loans and borrowings is currently RM303MIL now, compared to only RM67MIL in 2006. This is a substantial amount and the company is unlikely to be able to repay this withing a period of one year, since it’s’ cash balances are only RM32MIL. It must refinance these loans. Further scrutiny is required on the loans and borrowings amounts.

4. Taxation
These usually represents amount of tax payable to the Malaysian Inland Revenue. It is generally not significant in our evaluation of the value of a company as it is largely out of the company's control.

We have appraised and analyzed the major components of the current liabilities of Nestlé. The important components have been highlighted for further review, namely the inter-company payables and loans and borrowings. These will be looked in detail, in my future posts.

Saturday, June 7, 2008

Romance of the Three Kingdoms - Part V


The Battle of Red Cliff, Ensuing Ruse: 苦肉計 Gain a rival’s trust through self-mutilation

Despite Zhuge Liang’s earlier success in obtaining 100,000 arrows, a direct encounter between the Alliace with Cao Cao’s gargantuan fleet would still result in certain defeat for the former. The only viable strategy that could decimate Cao Cao’s forces with minimal losses would be to use a fire attack. Further, they would need to convince Cao Cao to chain his ships together so that massive damage and casualties could be inflicted on Cao Cao’s fleet by fire. To succeed, Cao Cao has to be swayed into making several fatal strategic missteps. I shall refer to this overall strategy as the 連環計 Symphony of Stratagems.

The problem was simple: How could this be done? The first piece of the puzzle:

Stratagem: 苦肉計 Gain a rival’s trust through self-mutilation

The only possible course open to the Alliance would be to convince Cao Cao to accept a *traitor* from the Alliance. This *traitor* would pretend to defect during the decisive engagement between Cao Cao and the Alliance. At an opportune moment, the *traitor* would launch a fire attack on Cao Cao’s forces throwing them into disarray.

By this time, Cao Cao was already an experienced general, whose strategic and tactical prowess was unquestioned. To convince him to accept any defectors from the Alliance, would require a high degree of subterfuge and corroborating evidence. Thus, the commanding officer of the Alliance, Zhou Yu decided on the 苦肉計 stratagem.

Huang Gai, a trusted general of the Wu Kingdom valiantly accepted the role of the *traitor*. In order to successfully feign desertion, he openly voiced his dissent against opposing Cao Cao, during a meeting between the Alliance’s commanding officers. Zhou Yu pretended to be furious at his lack of loyalty to the Wu Kingdom and sentenced him to be whipped 50 times. After the punishment, Huang Gai was in a deplorable state. His back was cut in many places, and the blood was flowing in streams.

News of Zhou Yu’s treatment of Huang Gai filtered back to Cao Cao. Through the use of a messenger, Cao Cao received Huang Gai’s letter offering to defect during the forthcoming decisive naval encounter between the opposing forces. Cao Cao had doubts as to whether the defection was genuine. However, Zhou Yu’s ingenious use of the 苦肉計 stratagem allayed his fears and concerns.

The first part of the Symphony of Stratagems has been set. We shall look at how other pieces of this grand strategy were put in place. The success or failure this stratagem, would determine the outcome of this decisive battle.

To first convince a rival to accept a turncoat from your faction, physical or mental self mutilation of your subordinate, at your hands, is necessary. This should suffice to allay any doubts or concerns by your rival, as to whether the defection is bona fide or otherwise. Simlarly, you should always be wary of renegades from the opposing camp, even those that have suffered horrendous mutilations at the hands of your rival, lest you fall foul of the 苦肉計 stratagem.

Friday, June 6, 2008

Analytical Review 101 – Part VIII

Inventory Turnover (Inventory Turn)

Always keep in mind that a company’s sole purpose is to generate profits and convert these profits into actual cash received. Therefore, a company with huge inventories, by itself, is meaningless. It is in the ability of the company to sell these inventories to its’ customers and convert them to actual CASH that is the crucial to the stability and profitability of a company. The Inventory Turn ratio is a key performance indicator of the company's ability to do so. The components of the Inventory Turn ratio are:

Cost of Goods Sold (COGS)
Cost of goods sold comprises of all direct costs attributable to the production of the goods sold by a company.

Inventories usually consists of raw and packaging materials, work-in-progress, finished goods and spare parts.

Significance of the Inventory Turn ratio
The Inventory Turn ratio allows us to analyze how long it takes for the company to convert its’ inventories into sales to its' customers. This inventory turnover will vary widely based on the industry the company is in. A company selling large, highly customized machineries will have a longer inventory turn compared to one in the Fast Moving Consumer Goods (FMCG) industry.

It is more significant to compare a company’s inventory turn ratio over a period of time or compare the inventory turn of a company with other companies in a similar industry. A short inventory turn (e.g. less that 60 days) is a favorable indicator, as it means the company is holding just sufficient stocks to meet customer demands and less cash is tied up in inventories.

On the other hand, if a company’s inventory turn ratio has increased dramatically over time (e.g. to 120 days currently, from 60 days in prior years), this means the company may be facing problems. A high ratio may indicate that its’ inventories are non-saleable or is facing an overstocking situation. This leads to increase in insurance costs, warehousing costs to house the inventories and possibility of obsolete and damaged stocks. The company may face liquidity issues as too much of its’ operating cash are now tied up in the increasing pile of inventories in its’ warehouses.

Analytical Review
Nestlé’s inventory turn ratio indicates a significant deterioration of over 26.8% as compared to last year. Its current inventory turn is now 71 days as compared to 56 days in 2006. This indicates that Nestlé’ is unable to convert its’ inventories to sales as efficiently as in prior years.

Revenues have only increased by 4.29%, yet inventories have increased significantly by 35%. This disproportionate increase in inventories as compared to revenue is highlighted by the deterioration in the inventory turn ratio. A substantial amount of Nestlé’s cash is tied up in its inventories, reducing its operating cash inflow for the year. Management must review this situation closely to ensure that the inventory is managed to prevent an overstock situation.

A high inventory turn ratio (especially compared to previous years or companies’ in a similar industry) is undesirable. This means that the company is unable to convert its’ stocks into sales to customers as efficiently as before. Consequently, additional insurance, warehousing and financing costs are incurred to maintain the higher level of inventories. Pay a close watch to the inventory turn ratio as it is a good key performance indicator of the Supply Chain Management function of a company.

Wednesday, June 4, 2008

Analytical Review 101 – Part VII

Day Sales Outstanding (DSO)

As reiterated (ad nauseam), CASH IS KING! To convert revenue into cash, one of the major areas a company must execute is to collect debts from its’ customers. This is represented by the DSO ratio, which is a key performance indicator (KPI) of the company’s credit control function. The DSO ratio is made up of two components, namely Trade Receivables and Revenue. Just to recap:

Trade Receivables
Trade Receivables consist of amounts due from customers. These amounts arise because most business gives credit period and limits to their customers. The average credit period given to customers vary depending on the industry they are in.

Revenue represents sales to customers for goods sold or services rendered.

Significance of the DSO ratio
The DSO ratio is important is it indicates the amount of time the company requires to collect the debts from the customers. A very long DSO ratio (e.g. in excess of 90 days) would indicate that the company is facing credit collection problems or the recoverability of such trade receivables is in doubt. Whenever the DSO ratios balloons substantially in comparison with prior years, it is an indication that the company may have expanded too aggressively or relaxed its’ credit control procedures in an attempt to secure additional sales.

Conversely, an favorable DSO ratio (i.e. 30-60 days) usually indicates that the company is managing its’ credit control function effectively and are collecting all its’ debts promptly. Companies with low DSO ratios are usually well managed and should not face any cash flow problems. When considering whether to invest in the shares of a particular company, a low DSO ratio is a very favorable sign.

Analytical Review
A review of Nestlé DSO ratio indicates that it has been hovering around 29 to 32 days. This is extremely favorable. On average, Nestlé takes approximately about a month to collect debts from its customers after it’s’ products are delivered and sold to its’ customers.

This is however, not surprising as the bulk of it’s’ customers are likely to consist of reputable dealers, supermarket and hypermarket chains that have strong financial standing. Further, there is a lower risk of any huge exposure of bad debts as compared to companies in other riskier industries such as construction industry.

By converting its’ trade receivables to cash in such a short time frame, Nestlé is able to generate strong operating cash flows of approximately RM319MIL per annum to sustain its’ operations.


Always keep a lookout for the DSO ratio. If profits has increased substantially but DSO ratio has ballooned (e.g. exceeding 90 days from 30 days in prior years), all is not well in the company. Ultimately, in order for profits to be realized, the debts from customers must be collected. If debts from customers are not collectible (bad debts), then the increase in profits is meaningless!

Monday, June 2, 2008

Romance of the Three Kingdoms – Part IV


The Battle of Red Cliffs, First Strike: 無中生有 Weaving Reality from Illusion

The Alliance of Sun Quan and Liu Bei were on perilous ground as they attempted to oppose the mighty hordes of Cao Cao. An analysis of Cao Cao’s army revealed that they were composed mainly of infantry and cavalry, with minimal experience in naval warfare. If the Alliance were to stand any chance of defending their homeland, they had to prevent Cao Cao’s army from crossing the Yangtze River. A decisive naval battle would have to be fought to determine the fate of China.

Although the Alliance’s 50,000 marines were highly experienced in naval warfare, the speed of Cao Cao’s southern campaign had taken them by surprise. In a naval battle, arrows were the most effective weapons. The Alliance would be able to decimate the hordes of Cao Cao without suffering any significant casualties in turn. However, they faced a significant problem.

Sun Quan and Liu Bei did not have sufficient arrows in their armories to supply the marines for such a decisive naval campaign. Without these armaments, no effective defense could be mounted against Cao Cao and eventual defeat was certain.

How many arrows would be required by the Alliance to supply their armies? 100,000 arrows!

How soon would they require them? 3 days!

Zhuge Liang was assigned this Herculean task to complete. Even though he was a master strategist, even he may have stretched himself too far. It would be impossible for the Alliance’s armories to build such a large number of arrows in such a short period. These arrows must obviously have to be already in existence. To borrow or obtain arrows from other neighboring states would take longer than three days.

There was only one source of arrows available –
from Cao Cao himself!

Stratagem: 無中生有 Weaving Reality from Illusion

In order to convince Cao Cao to *donate* arrows to the Alliance, Zhuge Liang had weave reality from illusion. How could he possibly do this?

The Illusion
He fashioned the illusion of a vast naval army by using twenty vessels each manned by thirty people. On each boat, he had cotton screens and bundles of straw lashed on the sides of the boats. Zhuge Liang waited until a night where it was very foggy and the river was dense with mist until one person could scarcely see one another.

As Cao Cao’s naval army was inexperienced and in a hostile environment, Zhuge Liang was certain that Cao Cao would not venture out of his camp at night to meet the Alliance’s naval army under such foggy and misty conditions. Knowing this, he instructed his vessels to form a straight line facing Cao Cao’s naval camp. Zhuge Liang’s marines then made a brouhaha that misled Cao Cao into thinking that the Alliance army had prepared an ambush and was goading them into attacking.

The Reality
Cao Cao then dispatched thousands of archers and crossbowmen lined up at the edge of his naval base to shoot at the bank to prevent any landings by the Alliance’s Navy. Arrows landed like rains that night hitting Zhuge Liang’s vessels until dawn. By then, the fog had dispersed and the twenty vessels commandeered by Zhuge Liang were bristling with arrows on both sides, sailing away too fast for Cao Cao's navy to give chase.

Using a cunning ruse, Zhuge Liang profited by 100,000 arrows whilst simultaneously depleting Cao Cao’s armories. Zhuge Liang deceived Cao Cao into surmising that the Alliance’s Navy was attacking his Cao Cao, when in reality – there was nothing there!

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