QIS Capital Conference October 2005

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QIS Capital Conference October 2005

• Exploring Fundamental Analysis
• Liquidity Ratios
• by Grant Robertson, B.B.A.

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• Key Principles of Fundamental Analysis
• no strict benchmarks fundamental analysis is
  relative measure and acceptable benchmarks may
  vary from industry to industry, stage of growth,
  etc.
• while some fundamental analysis measures are
  indeed objective, most still require subjective
  evaluation (it is merely one more tool that
  investors have at their disposal it will not
  make sound decisions for us).
• fundamental analysis is not only concerned with
  current state, but changes in key measures over
  time

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Working Capital

• Working Capital Current Assets - Current
  Liabilities
• The current assets and current liabilities
  figures can be found on the company's balance
  sheet.
• Current assets include
• Cash
• Short-term deposits
• Liquid marketable securities
• Accounts receivable
• Inventory
• Prepaid expenses
• Other assets which are expected to be or could
  easily be liquidated into cash within a period of
  one year or less.

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Working Capital Cont.

• Current liabilities include
• Short-term bank debt (demand loan or line of
  credit)
• Accounts payable
• Deposits received from customers for future
  delivery of products or services
• Taxes and payroll remittances payable to the
  government
• The portion of the company's long-term loans
  (principal) that will be repaid during the next
  12 months.
• Working capital essentially measures the
  company's ability to discharge all of its
  short-term obligations (those coming due within
  the next 12 months) without relying on operating
  cash flow and external financing.

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Working Capital Cont.

• Commonly measured by 2 key ratios
• Current Ratio Current Assets / Current
  Liabilities
• Ratio of 2.0 of higher preferred in most
  industries, although 1.0 for a profitable,
  growing small-cap is often sufficient to give
  comfort as to current financial liquidity where
  receivables and inventory turnover is stable or
  improving.
• Quick Ratio (Acid Test Ratio)
• (Current Assets Inventory) / Current
  Liabilities
• Ratio of at least 1.0 preferred in most
  industries.

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Working Capital Cont.

• Value to Investors / Analysts
• Measure of funds available to grow business
  without using operating cash flow or external
  financing
• Can help identify companies in need of additional
  financing so investor / analyst can take into
  account potential dilution from future share
  issuances, interest costs on financing, etc.
• Can be early indicator of financial insolvency,
  receivership, or bankruptcy, or alternatively an
  indicator of excess cash reserves which may
  indicate possibility of special dividend, hidden
  cash value, takeover candidate etc.
• Limitations
• Is only a snapshot of financial position as of a
  specific date, therefore, investor must consider
  changes in financing and operational activities
  since date of the balance sheet (private
  placements / offerings)
• Does not take into account debt service costs
  (interest on debt) and contingent liabilities,
  other debt covenants, etc.
• GAAP classification of certain demand loans (Oil
  Gas sector)

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Receivables Turnover

• In simple terms, this ratio measures how quickly
  the company can expect to get paid when it
  provides credit to its customers.
• Annual or Annualized Sales /
• Accounts Receivable
• Can also be expressed as days (easier to
  interpret)
• 365 days / Receivables Turnover Ratio
• Benchmarks
• Less than 30 days very good, 30-45 days good,
• 45-65 days fair, 65-90 poor, over 90 days very
  poor

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Receivables Turnover

• Uses
• reflects effectiveness of credit granting and
  collection policies
• can be used to identify impending bad debts and
  write-offs
• can reveal industry slowdown that may affect
  future business as customers extend credit as
  they begin to struggle with the industry slowdown
• Limitations
• must factor into account seasonality issues with
  respect to companys revenue stream
• can give misleading analysis results on smaller
  companies with lumpy revenue streams,
  especially those with unusually large contract
  revenues

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Receivables Turnover

• Best analysis value of this ratio comes from
  examining CHANGES in this ratio over time and
  compared to industry comparables
• Is the turnover of receivables slowing or
  becoming more rapid? A progressive slowing on
  the receivables turnover rate on a
  quarter-over-quarter basis is generally a cause
  for alarm. At the very least, it should raise
  questions for further due diligence.
• Can also be compared to payables turnover ratio
  (Cost of Goods Sold/Accounts Payable). An
  increase in accounts payable turnover and a
  slowdown in receivables turnover can quickly eat
  away at working capital and cash reserves.

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Inventory Turnover

• In simple terms, this ratio measures how long, on
  average, inventory must sit on the shelves
  before it is sold to a customer.
• Annual or Annualized Cost of Goods Sold /
• Inventory
• Can also be expressed as days (easier to
  interpret)
• 365 days / Inventory Turnover Ratio

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Inventory Turnover

• Uses
• can be used to identify obsolete inventory
  accumulation, reduction in product demand, new
  competition, over-production issues etc. which
  can hint as to future demand for product,
  possibility of write-offs, etc.
• Limitations
• must factor into account seasonality issues with
  respect to companys business and timing of
  inventory purchases (ex. build-up of retail
  inventories prior to Christmas season, or
  increase in inventory in anticipation of
  shipments for a major contract, etc.).
• inventory turnover depends greatly on the nature
  of the business being evaluated (fresh produce
  vs. jet aircraft)
• Best value comes from analyzing changes over time.

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Inventory Turnover

• General risks of holding too much inventory
• unnecessary use of capital that could be employed
  elsewhere
• increased warehousing cost, including insurance
• changes in prices (value), styles, or consumer
  acceptance
• General risks of holding too little inventory
• can't meet sales demand miss out on important
  sales opportunities
• unable to deliver product on time to meet
  customer requirements could result in customer
  switching to a more reliable supplier

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Summary

• it only takes a few minutes to do these basic
  calculations and they can reveal a great deal
  about a companys financial position
• focus on examining trends in changes in these
  ratios on a quarter by quarter basis
• it you find a concerning trend in a ratio, call
  management and ASK QUESTIONS and more
  importantly, scrutinize the answers you get.
• there are a series of three articles discussing
  working capital, receivables turnover and
  inventory turnover on the QIS Capital website in
  the educational articles section

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Example (PIH)

• Working Capital
• F05 11,199,272 4,524,629
  6,674,643
• F04 11,070,042 3,288,500
  7,781,542
• Current Ratio
• F05 11,199,272 / 4,524,629 2.5
• F04 11,070,042 / 3,288,500 3.4
• Quick (Acid Test) Ratio
• F05 (11,199,272 4,437,900) /
  4,524,629 1.5
• F04 (11,070,042 4,409,961) /
  3,288,500 2.0

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Example (PIH)

• Receivables Turnover
• F05 30,064,600 / 5,104,276 5.9 or
  62 days
• F04 26,440,172 / 4,182,210 6.3 or
  57 days
• Inventory Turnover
• F05 23,761,683 / 4,437,900 5.4 or
  68 days
• F04 20,767,735 / 4,409,961 4.7 or
  77 days