Friday, November 04, 2005

Basic understanding of inventories, trade debtors and trade creditors

When the profit is not reflected as positive net cash or net debt movement, the natural places to look for the profit are trade debtors and inventories/stocks.

Stocks, trade debtors and trade creditors are the natural path of business process.

When vendors deliver stocks or raw material, trade creditors and stocks increase. When a sales is made, stock reduce, trade debtors increase. When the company pays its vendors, trade creditors reduce. When the clients pay, trade debtors reduce.

When stock is obsolete, stock amount in Balance Sheet will increase. When clients refuse to pay, trade debtors increase. While the company still need to pay its trade creditors.

Essentially, trade debtors, stocks and trade creditors reflect business process in financial terms.

So it is BAD SIGN when stock and trade debtors increase. There is only ONE exception that should be tolerated by investors, with very strict conditions. We will deal with it later.
There are three reasons why S+TD-TC increase,
  • Bad operation, i.e. bad collection period, bad stock management, bad purchasing process, etc.
  • Profit manipulation, i.e. reversing previously provided provision for obsolete stocks or bad and doubtful debts, not making provision for uncollectible debts, not making provision for
  • Revenue growth

First and second items are bad. Third item MAY BE good, if the revenue growth exceeds the S+TD-TC's growth, proportionately. We, thus, need to do further calculation.

Calculate Net S+TD-TC turnover days:
S+TD-TC / Revenue (Turnover) per annum x 365, OR
S+TD-TC / Revenue (Turnover) per quarter x 92

Compare the number of current period with preceding period and previous year corresponding period. If current period’s S+TD-TC turnover increase (deteriorate/ slower/ lower) it reflects deterioration of operation efficiency or profit manipulation.

We can then further analyze the turnover days of each item, i.e. inventories/ stocks, trade debtors & trade creditors, separately.

Back to Step 3: inventories/stocks, trade debtors and trade creditors.