Mar 30, 2012|
'Our revenues doubled this year' ... so what?
Many a times you will find managements boasting about revenue growth in their respective companies' annual reports. Looking at annual reports of many companies during the high growth period a few years ago, you would have been astonished by the growth numbers.
Debtor days = Debtors/Sales * 365
High growth numbers are definitely good. But it is important that this growth should not be at the expense of the quality of the earnings.
While operating margins is one aspect, we are talking in terms of debtor days (aka receivable days). In simple terms, debtors are persons who owe money to a company. Such debts are on goods and services that are sold on credit. Sundry debtors can also be termed as 'accounts receivable'. The reason sundry debtors are recorded as an asset to a company is because the money belongs to the company, which it is supposed to receive within a certain period.
From an investor's perspective, it would help to analyse the speed at which a company is able to collect the money from its debtors. If a company's collection period is long and/or is expanding, it is not a good sign.
It must be kept in mind that a company could easily boost its revenues by loosening its credit policy - which is basically asking its buyers/ clients to pay after a longer period. While this would look good in terms of growth rates, it would deteriorate the quality of its balance sheet as more amount of money would be blocked towards the same.
The reason for having loose credit policies could vary from high competition leading to high pressure to grow business, risks of defaults being low during high growth periods, being a new player in an industry, amongst others.
At the end of the day, one should keep in mind the basics of working capital and its requirements. The same is to meet the requirements of daily operations of the business. With money not coming in on time, it would tend to put stress on the company, leading to it taking on debt and eventually, deteriorating the quality and health of its balance sheet. Thus, while having a strict credit policy in place does help to keep a check on things; it can have an impact on revenues (slow growth included) as not all of the company's debtors would agree to the stringent credit policy.
The ratio of receivable days is one that an investor needs to keep a watch on. It helps in analysing the number of days it takes a company to collect payments from its debtors. The formula for the same is:
Looking at this ratio in conjunction with receivables as a percentage of total sales, would give a clear picture on whether sales are real or nonexistent. For this, the investor should look at the growth in the company's sundry debtors numbers. If the growth in receivables outpaces that in sales, then there is a high probability that the revenue numbers are just that, numbers. Not reality.
Companies with an increase in receivable days
Data Source: ACE Equity; * - Ratio of increase in debtors / increase in sales growth over a
period of five years; Standalone data only
For the calculation to be more meaningful, we have removed banking and financial institutions as well as companies having average debtor days of less than 60 days. In the table 'L' stands for the latest available data, while 'L-5' is the data five years prior to the latest year.
We would like to reiterate that such figures should be compared to companies within a particular sector. Comparing companies across industries would throw up different numbers, purely due to the nature of the respective businesses. You, as a long term investor looking at fundamentals of a company, would do well by looking for companies that are already leaders or have a strong hold in their niche areas on industry they operates in.
||Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.
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