© 2000 John Petroff
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© 2000 John Petroff |
I- Analysis of current liabilities
Accounts payable turnover should be calculated with
A/P turnover = (Annual Purchases) / (Trade Payable)
But this definition of A/P turnover can only be used by inside analysts because annual purchases are not known to an outsider. In theory, the number could be estimated by remembering that cost of goods sold is equal to beginning inventory plus purchases less ending inventory. But the equation holds only for non-manufacturing firms because the finished goods inventory incorporates other direct costs than purchases and possibly allocated overhead. In addition, the calculated purchases would absorb all the likely distortions in inventory numbers, which are known to be numerous. To avoid calculating a grossly distorted number, cost of goods sold is used because its is reliable and is likely to be correlated with purchases. The A/P turnover is then defined as
A/P turnover = (Cost of Goods Sold) / (Trade Receivables)
Likewise, the Days Purchases Outstanding ratio should be specified as
DPO = (Accounts Payable) / (daily Purchases)
But most often, instead, Days Purchases Outstanding DPO is defined as
DPO = (Accounts Payable) / (Cost of Goods Sold/365)
As for accounts receivable and inventory, accounts payable have a seasonal pattern just as pronounced if not more. Averaging over the year would be desirable but it is rarely done. Also see Note N-8G2.1.
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As an example of DPO calculation, let us verify the value of 43 days, given for 1999 days purchases outstanding (DPO) in Timken_Ratios . For the first method of calculation we need the balance of trade payable of $ 236.6 millions from Timken Balance Sheet for 1999, and daily cost of sales obtained by dividing 1999 cost of goods sold of $ 2,002.4 millions taken from Timken Income Statement into 365, which gives $ 5.486 millions per day. Days purchases outstanding is DPO = 236.6 / 5.486 = 43.13 or 43 days The previous year Timken's DPO was 39 days. The ratio was higher than the median of 31 for steel manufacturers and 35 for auto parts manufacturers, both of which remained close to unchanged from prior years. Looking back at the analysis of Timken's DSO and DSI, the same conclusions are reached: a decreasing turnover. The change is especially noticeable in DPO which jumps by more than 10%. This suggests that the decreasing turnover ratios are not caused by individual assets or liabilities. One must suspect an overall decline in sales which was neither foreseen by management and nor experienced by the competition. |
To judge a firm's use of accounts
payable, days purchases outstanding should be compared to the
terms prevailing in the industry. In addition, two ratios occasionally
used to evaluate if a firm relies excessively or insufficiently
on short term credit, are
- Current Liabilities to Net Worth indicating the capital structure
of the firm,
- cash flow (i.e. net income plus depreciation) to current debt
ratio.
Generally, all firms in good standing will use the terms offered to them because it is the cheapest source of credit. If a firm has a much lower reliance on trade credit than its competitors, that may indicate that it has experienced difficulties paying on time in the past. (Note that both current and quick ratios would then be significantly improved.) But paying ahead of time can also save a lot if a cash discount is offered for early payment. The implied interest on early payment (taking advantage of cash discounts) is often much higher (e.g. over 20% in many cases as can observed in Note N-8I.1) than prevailing rates on marketable securities. It makes sense then to take advantage of these discounts.
An analyst must determine if a company may have potential short term liabilities that do not appear on the balance sheet. These may be guarantees given by the firm (on behalf of a subsidiary for instance), or claims of customers for returns or warranties, or rights of recourse of factors. See further discussion of credit as source of funds in Chapter 12 Section F.
See review questions Q-8I.1 through Q-8I.6.
See research assignments R-8I.1 and R-8I.2.
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