A Financial-Managerial Analysis

Operational Strengths & Weaknesses

Horizontal Analysis & Concerns

The analysis of dynamics in the key financials over the past few years suggests that the bargaining power of the company against the suppliers has worked both the ways. Whereas the sales revenues did soar an enviable 33.3% between year 6 and 7, COGS slightly under-reacted on the upside, which resulted in a moderate excess growth in the gross margin of 37.5-33.3=2.2% points. On the downside more recently, though, cost of sales sagged at a decelerating pace relative to revenues (14.5% versus 15.0% YOY), thus garnering a magnified decline in the gross margin at 16.3%.

On the operating expenses end, the advertising expenses must have been either ex-ante targeted or otherwise re-allocated ex-post to match the gross profit dynamics. On the other hand, the total selling expense has nearly co-moved with the sales (-14.9% down from the previous growth of 33% YOY). It should come as a little surprise that the ad expenses have been more margin-centered, albeit in a somewhat reactive way. The rest of the selling expense items have matched the sales dynamics one for one, which has slightly diluted the net response as pointed out.

When it comes to the G&A aggregate, only R&D has been tied into profitability in sync with the advertising expenses. There is no wonder that marketing and technical research has been intertwined in relying heavily on the performance reports, as well as the word-of-mouth implications. For that matter, it appears reasonable that, whereas the administrative salaries and executive compensations did grow on the upside (21.4% and 29.4% between year 6 and year 7), they have not changed through the recent downside transition. [In fact, the implied downside differential of 1.3% measures up against the upside gap of 2.2% at about the factor the posterior success rate of .6 compares to the failure odds of .4, with the CEO accountable for .6*40%=24% of growth and .4*40%=16% of the decline in sales, bearing in mind the insider stake. In operational terms, only about 33%*.24 of the past growth and 15%*.16 of the past decline could be attributed to the CEO, or 8% and 2.4% respectively, insofar as these are at all controllable rather than constituting an integral part of the fundamental risks.]

Flat depreciation suggesting no capex outlays may have been an ironically invariant response to skyrocketing growth and sheer stagnation alike. A similar reaction could have been expected with having an eye on the performance outliers or non-core dynamics, such as exceptional items and extraordinary events.

Operating income has changed at a magnified rate of 154.6% growth followed by a near 70% sag, with EBIT and net income amplified by an even higher extent to plummet 81.6% following a 313.4% soar. In fact, such a reversion throughout could largely be due to a baseline effect whereby it is utterly awkward to expect excessive or unrepresentative change to sustain. In our particular setting, the low-hurdle effect pertained to the small initial operating and the net margin residual.

In contrast, the balance sheet reveals an inverse liquidity pattern, with cash equivalents hitting a near 65% decline followed by spectacular growth at just under 350% YOY. In a sense, that may have echoed the working capital response, with some of the excess liquidity invested in inventory (31.8% growth) and channeled into the receivables (164.3% increment) initially. Anywhere near saturation, the company resorted to cash hoarding and harvesting, thus fostering a cash-cow turnaround, with a minor inventory overhang of 3.1% lending itself with a 15% decline in the receivables and the sales. Whereas in normal setups, shrinking receivables could have been deemed a desirable development pointing to improving the collection, in our case the big picture suggests the contrary.

On the liabilities end, growth in the accounts payable (192%) outmatched that in the receivables, only to keep growing at 33% and thereby contributing to liquidity buildup. For that matter, along the above lines, the retained earnings have been increasing at a decelerating pace (2.7% versus 17.4% YOY). A sharp reduction in the net earnings as opposed to stabilizing the retained earnings and equity could be signaling deteriorating performance ratios, such as ROE, with the leverage declining from about 5.6% to 5.9%.

Vertical Analysis & Concerns

The gross margin has been fairly stable at about 27% throughout. Whereas the total selling expense must have been targeted as a flat 6.7% proportion of the sales revenues (which holds on a per-item basis as well). The share of G&A and total operating expenses have oscillated in between 15.5% and 18.4% versus 22.1% and 25.1 % respectively. The operating income margin has decreased to 1.9% down from 5.3%, while EBIT and the net income have shown an even sharper fivefold contraction (.9% and .6% down from 4.4% and 2.8% respectively).

On the balance sheet, the proportion of current assets has grown steadily reaching 36.8% up from 24.5% — and so too have the current liabilities (7% up from 2.5% the other year). The apparent differential in the shares would suggest proper coverage, even though that should not imply optimal working capital management in light of the cash overhang (a 9.7% proportion up from 2.2% in the previous period). Whereas the fixed assets have retained their proportion at around 80%, this has to be adjusted to depreciation to arrive at the current asset share as above. Financial leverage, as represented by the debt ratio, has declined steadily albeit at a slowing rate and settling around 40%. As conjectured previously, equity has grown at a rather slow rate tapping a 53.8% share.

Trend Analysis & Concerns

The sales trends have apparently been depicted with reference to baseline years, which is year 6 for the historical time series and year 8 for projections. However, one would question the rationale behind a smooth if monotone forward-looking pattern despite a clear-cut oscillatory behavior in the past. It does not appear that any kind of weighted moving average has been implied, nor any path-dependent consistency for that matter. Although a longer-term forecast could build on lesser variability, it can hardly be at odds with the past fundamentals, much less given that the market conditions in sight are less than likely to change dramatically or prove downright unrelated to the economic cycle. On the second thought, a reversion pattern may have been replicated in the second-order effects, given that the sales are expected to grow at about 3% annually plus some volatile excess rate.

Ratio Analysis & Concerns

The current ratio has deteriorated somewhat (5.25 down from 5.79) while still suggesting the enviable coverage in absolute terms, as well as vis-?-vis the benchmark of 4.20. Solvency is secured bearing in mind the sharp proportion disparity of the current asset over current liabilities. The quick or acid-test ratio suggests the similar implications, net of the inventory, with the ongoing value of 4.14 measuring up against the 3.40 hurdle. In other words, even if the current assets mature twice as fast (e.g. as per the cash conversion terms of net 15 versus net 30 for the payables and receivables), there is enough cushion to meet the hot financing needs.

The stable average collection period of about 44 days implies a somewhat less favorable discipline relative to the benchmark of 33 days, which could qualify the aforementioned inference on net working capital. Worse yet, 44 days are just an average, with some receivables taking even longer to collect, and certainly longer than the 30 days setting the deadline for a 50% trade discount to apply. The slightly lower debt ratio hovering around 46% looks less favorable compared to the 38% hurdle in terms of the risks involved. On the other hand, a higher leverage (which captures the long-term debt only) could map to superior ROE performance, ROA held comparable. Although the latter prerequisite did hold initially (4.0% as compared to the 4.8% benchmark), both have collapsed to as low as 1.4% and .7% respectively. In fact, the long-term debt of the company would have to be boosted enormously for its ROE to recoup the status quo artificially while arbitrarily exposing itself to excessive risks and no valuation impact.

The times interest earned is yet another coverage ratio whose value has crashed along with the net margin, albeit from divergent starting positions relative to the applicable hurdles. Though superior looking initially (5.27 versus 4.24), the former metric has shown the deteriorating ability to meet the ongoing rollover needs (1.77 coverage), let alone take out another loan. The small and decaying net margin (.6% down from 2.8%) only renders benchmark comparison (5.1% margin) even more unfavorable, with the cost of debt likely to increase to accommodate a leverage boost, if any.

The P/E ratio is, in actuality, a multiple base which another company could be valued on. Though slightly overvalued initially (29.41 versus 29.0), the company could have seen its undervaluation upside increase by about 23.33/29.0-1, had it not been for the worsening fundamentals.

Working Capital

Improving WC

For starters, net working capital could be defined as the net current assets. In any event, it is a reduction in this metric that contributes to the cash flows indirectly. For the practical purposes, cash does not count toward productive working capital unless downside risk mitigation is at stake. It should be made apparent at this point that the quality of working capital counts no less heavily than its quantity when it comes to earning power over and above the trivial cash flow accounting. As it happens, the maturity structure of receivables versus payables could be one facet of that quality.

Mention was made in the previous sections of the collection terms having some implications for working capital management. Insofar as a 50% discount applies net 30, whereas the average collection period is 44 days, only a total of 14/44 of the receivables is full value nominally. That does not imply their effective value is very high. In fact, they might be subject to even heavier discounting or writing off. Nor does that suggest the receivables getting collected faster do not contribute enough value added. It should be noted that the surefire discount could be a hedging cost of bypassing the uncertainty. On the second thought, if the bulk of the receivables are subject to heavy discounting, that could be compromising profitability in its own right. In fact, rather than having 100% A/R, we end up confronting something like image2.png, which amounts to about 2/3 of our A/R. That value residual could prove even smaller if we were to apply a nonzero discount for the late collection, which, in fact, need not be lower than 50%. Suppose it is even higher, e.g. 60%. We obtain a residual of image4.png, or some 47% of the nominal receivables. We might, therefore, want either to offer a lower discount or to reduce the discount horizon in the terms offered.

As far as the operating and financial cycles are concerned, we have pointed out that delivery terms are twice as harsh for the company relative to its suppliers (net 30 versus 15). However, computing the full conversion cycle might mitigate the comparison toward, something like (25+30) versus (30+15). Apparently, 55/45 looks less of a gap compared to 30/15. However, if we are to invoke the real turnover or collection pattern in place of the nominal terms, the full conversion cycle makes (25+44) or 69 not 55. Incidentally, 69/45 looks close to 30/15. Again, they might want to go harder on their suppliers.

Using excess WC

Excess working capital could be imputed in a number of ways. On the one hand, the discounting implications as shown above have suggested that our receivables might be too low quality to strike a balance of profitability and liquidity. On the other hand, that implies excessive working capital requirements that have to be reduced by adjusting our terms. The fact that the incoming inventory churns over within 25 days would suggest roughly 5/30 or about 17% is held as stable monthly inventory cushion. In annual terms, that would be as low as 1.4%, which can hardly be kept even lower. However, it is the actual inventory, year-end or interim, that could be adjusted to this threshold.

When it comes to cash overhang as the least productive deployment of working capital, it has to be re-channeled to either more aggressive ad campaigns or social media marketing (SMM via the social networks) or to more proactive R&D beyond presuming the product quality and testing routines that are already high enough to secure a lead status.

Internal Controls

Weaknesses & Corrective Actions

The purchasing system might be deficient in just how it stresses input cost over quality. Reversing the priorities could secure a different bargaining vehicle while striking a better balance of efficacy (penetration and margin outcomes) and efficiency (the cost dimension would stay competitive regardless).

For that matter, even though the basic sequencing of paperwork and ordering processes (order followed by invoicing and payment, as well as shipment) appears correct, it may not secure the separation of duties to avoid the conflict of interest on several levels. For one, the purchasing department should check with the operations and not just planning as to whether the order quantity and price are near-optimal. Later on, the accounting should double-check it with operations, planning, and purchasing prior to signing the invoices to the treasury (if any), which level is accountable for the payments and conversion. This entire process could be simplified, as well as expedited by resorting to lock-in cooperation with the bank. In other words, there should be a separation or delegation at some levels versus cooperation or coordination at other ones, which are ultimately reconciled and facilitated via electronic technology and bank-handled channeling.

IC Risks & Mitigation

Technically, risk management and internal controls are largely distinct areas, albeit exhibiting a natural overlap. In a sense, they could be referred to as efficacy is to efficiency, or strategy and vision are to operations. Therefore, even though risks could pertain to operations, efficiency, and quality-driven effort, they cannot be studied in complete separation from the culture, the vision, and the ultimate strategies deliverables, such as quality, value, and reputation as a dimension of customer rapport. The bargaining-based contractual schemes might be safer than outsourcing, and direct FDI expansion should be more reliable than franchising, which alternatives suggest risk mitigation. More generally, mitigation may pertain to tradeoffs or risk functions akin to CVP cost functions or grand bridging devices, such as internal control,s as the upside of risk management. For instance, the company may want to trade some input cost for better input quality, but not the other way around, insofar as reputation is a major portal to retaining the market share. The latter, in turn, could secure the efficiency scale along the break-even lines, which is a mitigating tool in its own right. As long as efficiency is secured, the management of the company can focus on quality and reputation, thus building on the virtuous circle.

Alternatively, the company could accept some risks, particularly exogenous or market-related and non-specific, insofar as these cannot be diversified away due to lack of expansion or financing options. For that matter, the CEO could be more opportunity-driven rather than risk-averse, so that mitigation would amount to either acceptance or buy-in on the part of the human resource or otherwise re-building the team with an eye on viewing and sharing the culture of risk acceptance.

To draw a bottom line, draconian monitoring or meticulous reconciliation might not alone suffice. It could be far more beneficial to have a simple design that can be kept controllable and hence meaningful than it is to maintain a sophisticated system that keeps the user a dependable hostage unable to run the stress tests or to conduct the what-if analysis. Just like the otherwise superior CEO’s vision might not work out for lack of the buy-in, an operational and consistent heuristic could reward even for a partial loss of interim accuracy.

Sarbanes-Oxley Compliance

Non-Compliance & Corrective Action

Internal controls secure an important layer of managerial accounting and internal reporting filling the gaps of the manipulable external reporting. In the aftermath of the major corporate scams and securitization hype that has amplified the bubble bursts while rendering latent cumulative crises more of an issue, it has become apparent that the savvy investor might at times prove no more immune to manipulation. It has been made the executives’ liability, if only in line with social goodwill, to ensure the internal oversight while share in the risks and complexity involved. SOx addresses many of these areas while bridging the gap between the internal controls over potential risks versus the external reporting on the actual hazards and uncertainties.

Although SOx might be deemed more rewarding to the larger companies commanding enough scale to spread the fixed implicit cost of controlling across (as per section 404), it benefits the market leaders first and foremost. For instance, material misstatements of performance might be of importance, whether favorable or not. For instance, the company may over-report its depreciation in bona fide, while seeing no valuation impact over and above the income statement differentials. In actuality, the company might either understate its working capital at that rate or alternatively misallocate the fixed assets while calling for more—despite there being lower working capital and scale requirements. Hochberg, Sapienza, and Vissing-Jorgensen (2009) have established that, the SOx bargining conflict of investors versus the firm insiders has been all the more intense the heftier the hidden slacks at stake.

For that matter, the purchasing system may well have been prone to systemic overhang in the inventory or its insensitivity to the sales projections beyond the year-end proportion soaring as a seasonal cause. Likewise, the system might be exposed to either moral hazards or coordination failures, this locking in the human resources. The purchasing statistics might blur the actual efficiency figures. The analysis of variances and comparison to standards and benchmarks could be one way of viewing corrective action, which could be more proactive than corrective response.

Whereas section 401 could be applicable in addressing the off-balance items and operations (likely to carry over to manipulation-fragile social reputation and social cost absorption), section 302 might complement and reconcile internal controls and external reporting, inter alia.