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A quote from a series on reading a balance sheet:




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This Feature

Liquid: "Cash Is King?"
Current Assets
Current Liabilities
Debt & Equity
Current &
Quick Ratio
Working Capital
Price/Book,
DSO & Turns
Conclusion





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Price/Book, DSO & Turns

The last three ratios that you can derive from the balance sheet are the Price-to-Book Ratio, Days Sales Outstanding (DSO), and Inventory Turnover. I saved these for last because they are the most complicated.

The one of these that I think is absolutely useless is the venerable Price-to-Book Ratio. Conceived in a time when America was made up mainly of industrial companies that had actual hard assets like factories to back up their stock, its utility has waned in the past few decades as more and more companies that are not very capital intensive have grown and become commercial giants. The fact that Microsoft (Nasdaq: MSFT) doesn't have very much in the way of book value doesn't mean the company is overvalued -- it just means that the company does not need a lot of land and factories to make a very high-margin product.

Traditional book value is simply the shareholder's equity divided by the number of shares of stock outstanding. Since I think that it is more informative to look at the company as a whole, however, I do my price-to-book ratios using the aggregate market capitalization of the company divided by the current shareholder's equity. I also use something called Enterprise Value, which is market capitalization minus cash and equivalents plus debt. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company, they would get all the cash the company currently has, meaning it would effectively be deducted from the cost after the transaction was closed. The enterprise value (EV) to shareholder's equity (SE) looks like this, then:

(Shares Out * Price) + Debt - Cash
EV/SE = ------------------------------------
Shareholder's equity

This number will get you a simple multiple, much like the price/earnings ratio or the price/sales ratio. If it is below 1.0, then it means that the company is selling below book value and theoretically below its liquidation value. Some value investors will shun any companies that trade above 2.0 times book value or more.

Days Sales Outstanding is a measure of how many days worth of sales the current accounts receivable (A/R) represents. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine which player is managing its receivables collection better. A company with a lower amount of days worth of sales outstanding is getting its cash back quicker and hopefully putting it immediately to use, getting an edge on the competition. To figure out DSO, you first have to figure out Accounts Receivables Turnover. This is:

Sales for period
A/R Turnover = -----------------------
Average A/R for period

Sometimes you will only be able to get the accounts receivable from the last fiscal year, and therefore will have to use the revenues from the last fiscal year. However, the fresher the information, the better. What this ratio tells you is how many times in a year a company turns its accounts receivable. By "turn," I mean the number of times it completely clears all of the outstanding credit. For this number, higher is better. To turn this number into days sales outstanding, you do the following:

Current accounts receivable
DSO = --------------------------------
Sales for period divided by days in period

This tells you roughly how many days worth of sales are outstanding and not paid for at any given time. As you might have expected, the lower this number is, the better it is for the company. By comparing DSOs for various companies in the same industry, you can get a picture of which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.


I'm confused by what he (TMFTemplr) means in the DSO ratio calculation by "Current accounts receivable". Does he mean the entry of the same name on the balance sheet, or the A/R Turnover he calculated the paragraph before? I would think the Turnover, since he said it was needed to calculate the DSO.

Help?

JTrain
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Yuck, that didn't come out right, lemme try again:

Days Sales Outstanding is a measure of how many days worth of sales the current accounts receivable (A/R) represents. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine which player is managing its receivables collection better. A company with a lower amount of days worth of sales outstanding is getting its cash back quicker and hopefully putting it immediately to use, getting an edge on the competition. To figure out DSO, you first have to figure out Accounts Receivables Turnover. This is:

Sales for period
----------------------- = A/R Turnover
Average A/R for period

Sometimes you will only be able to get the accounts receivable from the last fiscal year, and therefore will have to use the revenues from the last fiscal year. However, the fresher the information, the better. What this ratio tells you is how many times in a year a company turns its accounts receivable. By "turn," I mean the number of times it completely clears all of the outstanding credit. For this number, higher is better. To turn this number into days sales outstanding, you do the following:

Current accounts receivable
-------------------------------- = DSO
Sales for period divided by days in period

This tells you roughly how many days worth of sales are outstanding and not paid for at any given time. As you might have expected, the lower this number is, the better it is for the company. By comparing DSOs for various companies in the same industry, you can get a picture of which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.


I'm confused by what he (TMFTemplr) means in the DSO ratio calculation by "Current accounts receivable". Does he mean the entry of the same name on the balance sheet, or the A/R Turnover he calculated the paragraph before? I would think the Turnover, since he said it was needed to calculate the DSO.

Help?

JTrain
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No. of Recommendations: 0
JTrain --

<<I'm confused by what he (TMFTemplr) means in the DSO ratio calculation by "Current accounts receivable". Does he mean the entry of the same name on the balance sheet, or the A/R Turnover he calculated the paragraph before? I would think the Turnover, since he said it was needed to calculate the DSO.>>

Here's my understanding, based on various snippets I've read in Fooldom:

A/R Turnover = Last 4 Quarters' Sales / Current Accounts Receivable

Days Sales Outstanding (DSO): Days sales outstanding is a measure of how many days worth of sales the current accounts receivable represents.

DSO: Days Sales Outstanding measures the company's control on receivables. A company whose DSO is 50 takes 50 days to collect accounts receivable. Smaller numbers mean the company can use that money---a good thing.

Days Sales Outstanding (DSO)
(From http://www.fool.com/portfolios/rulemaker/1999/rulemaker991102.htm)

On a quarterly basis, DSO is calculated using the following formula: Accounts receivable / (Sales / 90). If you want to calculate it for the year, you can substitute 360 for 90 in that equation. I like to see this figure as low as possible. A low figure means that the company collects its outstanding receivables quickly, which means that it's not giving out interest free loans to its customers for long periods of time.

Let's calculate this number for the second quarter of this year for both Pfizer and Warner-Lambert:

For..................Pfizer.....Warner-Lambert
Accounts Receivable...3,396.....1,949
Sales.................3,779.....3,151

For Pfizer we take 3,779 and divide it by 90, getting 41.99. We then take that figure and divide it into 3,396. The result is that it takes Pfizer 81 days to collect its outstanding accounts receivable, which is higher than any other pharmaceutical company I've studied. If you do this same calculation for
Warner-Lambert, you'll get a result of 56 days. Looking at those numbers, I'd much rather owe money to Pfizer than Warner-Lambert, as Pfizer would give me 25 extra days to pay.

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