Financial Statement Analysis – Explained.

What Does Enterprise Value Tell You?

Enterprise value (EV) could be thought of like the theoretical takeover price if a company were to be
bought. EV differs significantly from simple market capitalization in several ways, and many consider
it to be a more accurate representation of a firm's value. The value of a firm's debt, for example,
would need to be paid off by the buyer when taking over a company. As a result, enterprise value
provides a much more accurate takeover valuation because it includes debt in its value calculation.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of important
factors out, such as a company's debt on the one hand and its cash reserves on the other. Enterprise
value is basically a modification of market cap, as it incorporates debt and cash for determining a
company's valuation.

Market capitalization is not intended to represent a company's book value. Instead, it represent's a
company's value as determined by market participants.

Misconceptions About Market Caps

Although it is used often to describe a company, market cap does not measure the equity value of a
company. Only a thorough analysis of a company's fundamentals can do that. It is inadequate to
value a company because the market price on which it is based does not necessarily reflect how
much a piece of the business is worth. Shares are often over- or undervalued by the market,
meaning the market price determines only how much the market is willing to pay for its shares.

Although it measures the cost of buying all of a company's shares, the market cap does not
determine the amount the company would cost to acquire in a merger transaction. A better method
of calculating the price of acquiring a business outright is the enterprise value.

Changes in Market Cap

Two main factors can alter company's market cap: significant changes in the price of a stock or when
a company issues or repurchases shares. An investor who exercises a large number of warrants can
also increase the amount of shares on the market and negatively affect shareholders in a process
known as dilution.

Valuation From P/E

The price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by
investors and analysts for determining stock valuation. In addition to showing whether a company's
stock price is overvalued or undervalued, the P/E can reveal how a stock's valuation compares to its
industry group or a benchmark like the S&P 500 Index.

In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in
a company in order to receive one dollar of that company’s earnings. This is why the P/E is
sometimes referred to as the price multiple because it shows how much investors are willing to pay
per dollar of earnings. If a company was currently trading at a P/E multiple of 20x, the interpretation
is that an investor is willing to pay $20 for $1 of current earnings.

The P/E ratio helps investors determine the market value of a stock as compared to the company's
earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on
its past or future earnings. A high P/E could mean that a stock's price is high relative to earnings and
possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative
to earnings.

Understanding Dividend Yield

The dividend yield is an estimate of the dividend-only return of a stock investment. Assuming the
dividend is not raised or lowered, the yield will rise when the price of the stock falls. And conversely,
it will fall when the price of the stock rises. Because dividend yields change relative to the stock
price, it can often look unusually high for stocks that are falling in value quickly.

New companies that are relatively small, but still growing quickly, may pay a lower average dividend
than mature companies in the same sectors. In general, mature companies that aren't growing very
quickly pay the highest dividend yields. Consumer non-cyclical stocks that market staple items or
utilities are examples of entire sectors that pay the highest average yield.

What Does Return on Capital Employed Tell You?

ROCE can be especially useful when comparing the performance of companies in capital-intensive
sectors, such as utilities and telecoms. This is because unlike other fundamentals such as return on
equity (ROE), which only analyzes profitability related to a company’s shareholders’ equity, ROCE
considers debt and equity. This can help neutralize financial performance analysis for companies
with significant debt.

Ultimately, the calculation of ROCE tells you the amount of profit a company is generating per $1 of
capital employed. Obviously, the more profit per $1 a company can generate the better. Thus, a
higher ROCE indicates stronger profitability across company comparisons.
For a company, the ROCE trend over the years can also be an important indicator of performance. In
general, investors tend to favor companies with stable and rising ROCE levels over companies where
ROCE is volatile or trending lower.

What Does ROE Tell You?

Whether ROE is deemed good or bad will depend on what is normal among a stock’s peers. For
example, utilities have many assets and debt on the balance sheet compared to a relatively small
amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail
firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18%
or more.

A good rule of thumb is to target an ROE that is equal to or just above the average for the peer
group. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last
few years compared to the average of its peers, which was 15%. An investor could conclude that
TechCo’s management is above average at using the company’s assets to create profits. Relatively
high or low ROE ratios will vary significantly from one industry group or sector to another. When
used to evaluate one company to another similar company, the comparison will be more
meaningful. A common shortcut for investors is to consider a return on equity near the long-term
average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

Using ROE to Estimate Growth Rates

Sustainable growth rates and dividend growth rates can be estimated using ROE, assuming that the
ratio is roughly in line or just above its peer group average. Although there may be some challenges,
ROE can be a good starting place for developing future estimates of a stock’s growth rate and the
growth rate of its dividends. These two calculations are functions of each other and can be used to
make an easier comparison between similar companies.

To estimate a company’s future growth rate, multiply the ROE by the company’s retention ratio. The
retention ratio is the percentage of net income that is retained or reinvested by the company to
fund future growth.

ROE and a Sustainable Growth Rate

Assume that there are two companies with an identical ROE and net income, but different retention
ratios. Company A has an ROE of 15% and returns 30% of its net income to shareholders in a
dividend, which means company A retains 70% of its net income. Business B also has an ROE of 15%
but returns only 10% of its net income to shareholders for a retention ratio of 90%.
For company A, the growth rate is 10.5%, or ROE times the retention ratio, which is 15% times 70%.
Business B's growth rate is 13.5%, or 15% times 90%.

This analysis is referred to as the sustainable growth rate model. Investors can use this model to
make estimates about the future and to identify stocks that may be risky because they are running
ahead of their sustainable growth ability. A stock that is growing slower than its sustainable rate
could be undervalued, or the market may be discounting risky signs from the company. In either
case, a growth rate that is far above or below the sustainable rate warrants additional investigation.

This comparison seems to make business B more attractive than company A, but it ignores the
advantages of a higher dividend rate that may be favored by some investors. We can modify the
calculation to estimate the stock’s dividend growth rate, which may be more important to income
investors.

Using ROE to Identify Problems

It is reasonable to wonder why an average or slightly above average ROE is good rather than an ROE
that is double, triple, or even higher the average of their peer group. Aren’t stocks with a very high
ROE a better value?

Sometimes an extremely high ROE is a good thing if net income is extremely large compared to
equity because a company’s performance is so strong. However, an extremely high ROE is often due
to a small equity account compared to net income, which indicates risk.

Inconsistent Profits

The first potential issue with a high ROE could be inconsistent profits. Imagine a company, LossCo,
that has been unprofitable for several years. Each year’s losses are recorded on the balance sheet in
the equity portion as a “retained loss.” The losses are a negative value and reduce shareholder
equity. Assume that LossCo has had a windfall in the most recent year and has returned to
profitability. The denominator in the ROE calculation is now very small after many years of losses,
which makes its ROE misleadingly high.

Excess Debt

A second issue that could cause a high ROE is excess debt. If a company has been borrowing
aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a
company has, the lower equity can fall. A common scenario is when a company borrows large
amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it does not
affect actual performance or growth rates.

Negative Net Income

Finally, negative net income and negative shareholder equity can create an artificially high ROE.
However, if a company has a net loss or negative shareholders’ equity, ROE should not be calculated.

If shareholders’ equity is negative, the most common issue is excessive debt or inconsistent
profitability. However, there are exceptions to that rule for companies that are profitable and have
been using cash flow to buy back their own shares. For many companies, this is an alternative to
paying dividends, and it can eventually reduce equity (buybacks are subtracted from equity) enough
to turn the calculation negative.

In all cases, negative or extremely high ROE levels should be considered a warning sign worth
investigating. In rare cases, a negative ROE ratio could be due to a cash flow supported share
buyback program and excellent management, but this is the less likely outcome. In any case, a
company with a negative ROE cannot be evaluated against other stocks with positive ROE ratios.

Limitations of ROE

A high ROE might not always be positive. An outsized ROE can be indicative of a number of issues—
such as inconsistent profits or excessive debt. Also, a negative ROE due to the company having a net
loss or negative shareholders’ equity cannot be used to analyze the company, nor can it be used to
compare against companies with a positive ROE.

Understanding How Working Capital Is Used

Working capital—also called net working capital—reflects the amount of money a company has at
its disposal to pay for immediate expenses. Of course, the more working capital, the better it for a
company's financial situation. The amount of working capital a company needs to run smoothly can
vary widely. Some businesses require increased amounts of working capital to cope with expenses
that ebb and flow seasonally.

For example, retail businesses often experience a spike in sales during certain times of the year, such
as the holiday season. Retailers need an increased amount of working capital to pay for the
additional inventory and staff that'll be needed for the high-demand season. As a result, a retailer
would likely see higher expenses in the off-season relative to revenues leading up to the holidays.
 Conversely, when sales are down in the off-season, the company would still need to pay for its
normal staffing despite lower sales revenue. Working capital helps businesses smooth out the gaps
in revenue during the times of the year when sales are slow.

Oftentimes, banks will lend to companies providing a working capital credit line, which allows
companies to tap into during off-peak seasons when there are capital shortfalls. As a result,
company executives as well as banks that lend to companies monitor working capital very closely. In
order to understand a company's working capital needs, it's critical to know the specific items that
can lead to increases or decreases in working capital.

Drivers of Working Capital

Companies have both short-term assets and liabilities. A company's short-term assets are called
current assets, while short-term liabilities are called current liabilities. A company's working capital is
the difference between the value of the current assets and its current liabilities for the period.

Current Assets

A current asset is an asset that is available for use within the next 12 months. Current assets are a
company's short-term assets that can be easily liquidated—or converted into cash—and used to pay
debts within the next year.

Current assets typically include:

Cash and cash equivalents—including cash, such as funds in checking or savings accounts, while cash
equivalents are highly-liquid assets, such as money-market funds and Treasury bills

Marketable securities—such as stocks, mutual fund shares, and some types of bonds

Inventory—the merchandise that can be quickly sold or liquidated in less than one year

Accounts receivable or money owed to the company by its customers or other debtors for products
and services sold

Current Liabilities

A current liability is a short-term expense that a company owes and must pay within a 12-month
period. Current liabilities can include:
Short-term debt payments, which can include payments for bank loans or commercial paper issued
to fund operations

Suppliers and vendors owed for inventory, raw materials, and services, such as technology support

Accounts payable, which are short-term bills owed

Interest payments due to bondholders and banks, which can include interest owed on short-term
debt as well as the current interest payments due for long-term debt

Taxes owed, such as income and payroll taxes due in the next year

The total amount of a company's current liabilities changes over time—similar to current assets—
since it's based on a rolling 12-month period.

Interpreting and Adjusting Working Capital

Since working capital is equal to the difference between current assets and current liabilities, it can
be either a positive or a negative number. Of course, positive working capital is always preferable
since it means a company has enough to pay its operating expenses. However, the net working
capital figure can change over time, causing the company to experience periods of negative working
capital due to unexpected short-term expenses.

Conversely, a company that has consistently excessive working capital may not be making the most
of its assets. While positive working capital is good, having too much cash sit idle can hurt a
company. Those idle funds could be used for paying down debt, or investing in the long-term future
of the company by purchasing long-term assets, such as technology.

Companies monitor their accounts receivables to determine when they're expected to receive
payment from their customers. On the other hand, companies also monitor their accounts payables
to determine the dates in which payments are due to suppliers. If the accounts payables are due
sooner than the money due from the accounts receivables, the company can experience a working
capital shortfall.

As a result, companies may offer incentives to their customers to collect the receivables sooner.
Conversely, a company may also ask its supplier for better terms allowing the company to pay at a
later date. Monitoring and analyzing working capital helps companies manage their cash flow needs
so that they can meet their operating expenses in the coming months.

Understanding EBITDA/EV Multiple

 EBITDA/EV is a comparables analysis method that seeks to value similar companies using the same
financial metrics. While computing the EBITDA/EV ratio is more complicated than other return
measures, it is sometimes preferred because it provides a normalized ratio for comparing the
operations of different companies.

If a more conventional ratio (such as net income to equity) were used, comparisons would be
skewed by each company's accounting policies.

An analyst using EBITDA/EV assumes that a particular ratio is applicable and can be applied to
various companies operating within the same line of business or industry. In other words, the theory
is that when firms are comparable, this multiples approach can be used to determine the value of
one firm based on the value of another. Thus, EBITDA/EV is commonly used to compare companies
within an industry.

KEY TAKEAWAYS

The EBITDA/EV multiple is a financial valuation ratio used to calculate a company's ROI.

EBITDA/EV ratio is more complicated than other return measures, but it often used because it
provides a normalized ratio for measuring the operations of different companies.

The enterprise value (EV) ratio harmonizes within the capital structure of a company.

This is a modification of the ratio of operating and non-operating profits compared to the market
value of a company's equity plus its debt. Since EBITDA is often considered a proxy for cash income,
the metric is used as a measure of a company's cash return on investment.

What Does the Price/Earnings-to-Growth Ratio Tell You?

While a low P/E ratio may make a stock look like a good buy, factoring in the company's growth rate
to get the stock's PEG ratio may tell a different story. The lower the PEG ratio, the more the stock
may be undervalued given its future earnings expectations. Adding a company's expected growth
into the ratio helps to adjust the result for companies that may have a high growth rate and a high
P/E ratio.

The degree to which a PEG ratio result indicates an over or underpriced stock varies by industry and
by company type. As a broad rule of thumb, some investors feel that a PEG ratio below one is
desirable.

According to well-known investor Peter Lynch, a company's P/E and expected growth should be
equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company's
PEG exceeds 1.0, it's considered overvalued while a stock with a PEG of less than 1.0 is considered
undervalued.2

Example of How to Use the PEG Ratio

The PEG ratio provides useful information to compare companies and see which stock might be the
better choice for an investor's needs, as follows.

Assume the following data for two hypothetical companies, Company A and Company B:

Company A:

Price per share = $46

EPS this year = $2.09

EPS last year = $1.74

Company B

Price per share = $80

EPS this year = $2.67

EPS last year = $1.78

Given this information, the following data can be calculated for each company.

Company A

P/E ratio = $46 / $2.09 = 22

Earnings growth rate = ($2.09 / $1.74) - 1 = 20%

PEG ratio = 22 / 20 = 1.1

Company B

P/E ratio = $80 / $2.67 = 30

Earnings growth rate = ($2.67 / $1.78) - 1 = 50%

PEG ratio = 30 / 50 = 0.6

 Many investors may look at Company A and find it more attractive since it has a lower P/E ratio
between the two companies. But compared to Company B, it doesn't have a high enough growth
rate to justify its P/E. Company B is trading at a discount to its growth rate and investors purchasing
it are paying less per unit of earnings growth.

Free Cash Flow vs. Operating Cash Flow: An Overview

Free cash flow is the cash that a company generates from its normal business operations after
subtracting any money spent on capital expenditures. Capital expenditures or CAPEX for short, are
purchases of long-term fixed assets, such as property, plant, and equipment.

On the other hand, operating cash flow is the cash that's generated from normal business operations
or activities. Operating cash flow shows whether a company generates enough positive cash flow to
run its business and grow its operations.

Free cash flow and operating cash flow are often used as metrics when comparing competitors in the
same or comparable industries. Operating cash flow, free cash flow, and earnings are all important
metrics when researching and evaluating a company that is being considered for investment.

KEY TAKEAWAYS

Operating cash flow measures cash generated by a company's business operations.

Free cash flow is the cash that a company generates from its business operations after subtracting
capital expenditures.

Operating cash flow tells investors whether a company has enough cash flow to pay their bills.

Free cash flow tells investors and creditors that there's enough cash remaining to pay back creditors,
pay dividends, and buyback shares.

Operating Cash Flow

Operating cash flow is an important metric because it shows investors whether or not a company
has enough funds coming in to pay its bills or operating expenses. In other words, there must be
more operating cash inflows than cash outflows for a company to be financially viable in the long-
term.

Operating cash flow is calculated by taking revenue and subtracting operating expenses for the
period. Operating cash flow is recorded on a company's cash flow statement, which is reported both
on a quarterly and annual basis. Operating cash flow indicates whether a company can generate
enough cash flow to maintain and expand operations, but it can also indicate when a company may
need external financing for capital expansion.

Limitations of Operating Cash Flow

However, there are limitations to using operating cash flow as a cash flow metric. It is important to
determine the source of a company's cash flow. For example, a company might increase its cash flow
for the quarter because it sold assets, such as equipment. In other words, a company with increasing
cash flow isn't necessarily more profitable, nor does it mean that the company's sales or revenues
increased.

Also, a company that generated a large sale from a client would lead to a boost in revenue and
earnings. However, the additional revenue doesn't necessarily improve cash flow. For example, if the
company had difficulty collecting the payment from the customer, operating cash flow would be
negatively impacted.

That's why it's important for investors to analyze the inflows and outflows of operating cash flow
and determine where the money is coming from and where the money is going.

Free Cash Flow

For investors, there is no set number listed on a company's financial statements that's States the
exact amount of cash that they would receive for owning the company's stock. Free cash flow
represents the cash flow that is available to all investors before cash is paid out to make debt
payments, dividends, or share repurchases.

Free cash flow is typically calculated as a company's operating cash flow after subtracting any capital
purchases. Capital expenditures are funds a company uses to buy, upgrade, and maintain physical
assets, including property, buildings, or equipment. In other words, free cash flow helps investors
determine how well a company generates cash from operations but also how much cash is impacted
by capital expenditures. Free cash flow can be envisioned as cash left after the financing of projects
to maintain or expand the asset base.

Free cash flow is a measure of financial performance, similar to earnings, and its use is considered to
be one of the non-Generally Accepted Accounting Principles (GAAP).
 Free Cash Flow and Dividends

The amount of cash flow available is usually used to calculate how likely a company can make its
dividend payments. Dividends are cash payments to investors as a reward for owning the stock. If a
company is generating free cash flow that exceeds dividend payments, it's likely to be seen as
favorable to investors, and it could mean that the company has enough cash to increase the
dividend in the future.

Also, investors can take a company's free cash flow figure and subtract the company's interest and
debt payments to determine how much cash is remaining to pay for dividends.

Many analysts feel dividend outlays are just as important an expense as capital expenditures. The
board of directors of a company may elect to reduce a dividend payment. However, this usually has
a negative effect on the stock price, as investors tend to sell holdings in companies that reduce
dividends.

Free Cash Flow and Creditors

Free cash flow measures the cash flow available for distribution to all company securities holders,
including creditors. Banks that lend to companies want the company to be able to generate free cash
flow so that the company is able to pay back the debt.

If a company wanted to borrow an additional amount of money from their bank, the lender would
use free cash flow to determine the amount of loan the company could repay. The lender would
subtract the current debt payments from free cash flow to determine the amount of cash flow
available to pay for additional borrowings.

Limitations of Free Cash Flow

However, there are limitations to free cash flow, including companies that have significant capital
purchases. For example, some industries are very capital intensive, such as the oil and gas industry.
Oil companies must purchase or invest a significant amount of capital in fixed assets, such as
machinery and drilling equipment. As a result, free cash flow can be inconsistent over time since
these significant capital outlays of cash are needed.

It's important that investors compare free cash flow with similar companies or industries. It doesn't
make sense to compare the free cash flow of an oil company with the free cash flow of a marketing
firm that has no significant capital purchases or fixed assets.
 Companies with positive free cash flow are able to expand their business while those with falling
free cash flow might need restructuring or additional financing.

Free Cash Flow vs. Operating Cash Flow Examples

Below is the cash flow statement for Apple Inc. (AAPL) as reported in the company's 10-Q filing for
the period ending December 28, 2019.

Operating Cash Flow

At the top of the cash flow statement, we can see that Apple carried over $50.224 billion in cash
from the balance sheet and $22.236 billion in net income or profit from the income statement. Once
the day-to-day operating expenses are deducted, we arrive at the company's operating cash flow.

Apple recorded $30,516 billion in operating cash flow (highlighted in green). The aggregate amount
of operating cash flow included the daily operating activities, such as:

Inventory purchases for $28 million

Accounts receivables for $2.015 billion, which represents money owed to Apple by its customers for
booked sales

Accounts payables of $1.089 billion, which is money owed by Apple to its suppliers and vendors

Free Cash Flow

Apple invested in a new plant and equipment, purchasing $2.107 billion in assets (in red). The
purchase is a cash outlay.

We already know that the company's operating cash flow was $30.516 billion.

As a result, Apple's free cash flow was $28.409 billion for the period ($30.516 - $2.107).

To manufacture a salable product, a company needs raw material and other resources which form
the inventory and come at a cost. Additionally, there is a cost linked to the manufacturing of the
salable product using the inventory. Such costs include labor costs and payments towards utilities
like electricity, which is represented by the cost of goods sold (COGS) and is defined as the cost of
acquiring or manufacturing the products that a company sells during a period. DSI is calculated
based on the average value of the inventory and cost of goods sold during a given period or as of a
particular date. Mathematically, the number of days in the corresponding period is calculated using
365 for a year and 90 for a quarter. In some cases, 360 days is used instead.
 The numerator figure represents the valuation of the inventory. The denominator (Cost of Sales /
Number of Days) represents the average per day cost being spent by the company for manufacturing
a salable product. The net factor gives the average number of days taken by the company to clear
the inventory it possesses.

Two different versions of the DSI formula can be used depending upon the accounting practices. In
the first version, the average inventory amount is taken as the figure reported at the end of the
accounting period, such as at the end of the fiscal year ending June 30. This version represents DSI
value “as of” the mentioned date. In another version, the average value of Start Date Inventory and
End Date Inventory is taken, and the resulting figure represents DSI value “during” that particular
period. Therefore,

\text{Average Inventory} = \text{Ending Inventory}Average Inventory=Ending Inventory

or

\text{Average Inventory} = \frac{(\text{Beginning Inventory} + \text{Ending Inventory})}{2}Average

Inventory=

(Beginning Inventory+Ending Inventory)

COGS value remains the same in both the versions.

KEY TAKEAWAYS

Days sales of inventory (DSI) is the average number of days it takes for a firm to sell off inventory.

DSI is a metric that analysts use to determine the efficiency of sales.

A high DSI can indicate that a firm is not properly managing its inventory or that it has inventory that
is difficult to sell.

What DSI Tells You

Since DSI indicates the duration of time a company’s cash is tied up in its inventory, a smaller value
of DSI is preferred. A smaller number indicates that a company is more efficiently and frequently
selling off its inventory, which means rapid turnover leading to the potential for higher profits
(assuming that sales are being made in profit). On the other hand, a large DSI value indicates that
the company may be struggling with obsolete, high-volume inventory and may have invested too
much into the same. It is also possible that the company may be retaining high inventory levels in
order to achieve high order fulfillment rates, such as in anticipation of bumper sales during an
upcoming holiday season.

DSI is a measure of the effectiveness of inventory management by a company. Inventory forms a

significant chunk of the operational capital requirements for a business. By calculating the number of
days that a company holds onto the inventory before it is able to sell it, this efficiency ratio measures
the average length of time that a company’s cash is locked up in the inventory.

However, this number should be looked upon cautiously as it often lacks context. DSI tends to vary
greatly among industries depending on various factors like product type and business model.
Therefore, it is important to compare the value among the same sector peer companies. Companies
in the technology, automobile, and furniture sectors can afford to hold on to their inventories for
long, but those in the business of perishable or fast moving consumer goods (FMCG) cannot.
Therefore, sector-specific comparisons should be made for DSI values.

One must also note that a high DSI value may be preferred at times depending on the market
dynamics. If a short supply is expected for a particular product in the next quarter, a business may be
better off holding on to its inventory and then selling it later for a much higher price, thus leading to
improved profits in the long run.

For example, a drought situation in a particular soft water region may mean that authorities will be
forced to supply water from another area where water quality is hard. It may lead to a surge in
demand for water purifiers after a certain period, which may benefit the companies if they hold onto
inventories.

Irrespective of the single-value figure indicated by DSI, the company management should find a
mutually beneficial balance between optimal inventory levels and market demand.
 DSI vs. Inventory Turnover

A similar ratio related to DSI is inventory turnover, which refers to the number of times a company is
able to sell or use its inventory over the course of a particular time period, such as quarterly or
annually. Inventory turnover is calculated as the cost of goods sold divided by average inventory. It is
linked to DSI via the following relationship:

DSI = \frac{1}{\text{inventory turnover}}\times 365 \text{ days}DSI=

inventory turnover

×365 days

Basically, DSI is an inverse of inventory turnover over a given period. Higher DSI means lower
turnover and vice versa.

In general, the higher the inventory turnover ratio, the better it is for the company, as it indicates a
greater generation of sales. A smaller inventory and the same amount of sales will also result in high
inventory turnover. In some cases, if the demand for a product outweighs the inventory on hand, a
company will see a loss in sales despite the high turnover ratio, thus confirming the importance of
contextualizing these figures by comparing them against those of industry competitors.

DSI is the first part of the three-part cash conversion cycle (CCC), which represents the overall
process of turning raw materials into realizable cash from sales. The other two stages are days sales
outstanding (DSO) and days payable outstanding (DPO). While the DSO ratio measures how long it
takes a company to receive payment on accounts receivable, the DPO value measures how long it
takes a company to pay off its accounts payable. Overall, the CCC value attempts to measure the
average duration of time for which each net input dollar (cash) is tied up in the production and sales
process before it gets converted into cash received through sales made to customers.

Why the DSI Matters

Managing inventory levels is vital for most businesses, and it is especially important for retail
companies or those selling physical goods. While the inventory turnover ratio is one of the best
 indicators of a company’s level of efficiency at turning over its inventory and generating sales from
that inventory, the days sales of inventory ratio goes a step further by putting that figure into a daily
context and providing a more accurate picture of the company’s inventory management and overall
efficiency.

DSI and inventory turnover ratio can help investors to know whether a company can effectively
manage its inventory when compared to competitors. A 2014 paper in Management Science, "Does
Inventory Productivity Predict Future Stock Returns? A Retailing Industry Perspective," suggests that
stocks in companies with high inventory ratios tend to outperform industry averages.1 2 A stock
that brings in a higher gross margin than predicted can give investors an edge over competitors due
to the potential surprise factor. Conversely, a low inventory ratio may suggest overstocking, market
or product deficiencies, or otherwise poorly managed inventory–signs that generally do not bode
well for a company’s overall productivity and performance.

Example of DSI

The leading retail corporation Walmart (WMT) had inventory worth $43.78 billion and cost of goods
sold worth $373.4 billion for the fiscal year 2018.3 While inventory value is available in the balance
sheet of the company, the COGS value can be sourced from the annual financial statement. Care
should be taken to include the sum total of all the categories of inventory which includes finished
goods, work in progress, raw materials, and progress payments. Since Walmart is a retailer, it does
not have any raw material, work in progress and progress payments. Its entire inventory is
comprised of finished goods. Using 365 as the number of days for the annual calculation, the DSI for
Walmart is

[\frac{43.78} {(373.4/365)}] = 42.79 \text{ days}[

(373.4/365)

43.78

]=42.79 days

Technology leader Microsoft (MSFT) had $2.66 billion as total inventory and $38.35 billion as COGS
at the end of its fiscal year 2018. Since Microsoft creates software and hardware products, it has its
inventory spread across finished goods ($1.95 billion), work in progress ($54 million) and raw
materials ($655 million).4 Microsoft’s DSI value is:
 [\frac{2.66} {(38.97/365)}] = 24.91 \text{ days}[

(38.97/365)

2.66

]=24.91 days

These figures indicate that Walmart had a longer period of around 43 days to clear its inventory,
while Microsoft took around 25 days.

A look at similar figures for the online retail giant Amazon (AMZN), which had a total inventory of
$17.17 billion and COGS of $139.16 billion for the fiscal year 2018, reveals a relatively high value of
45.03 days.5 While both Walmart and Amazon are leading retailers, the mode of their operations
explains the higher DSI value for the latter. Walmart sees a lot of foot traffic in its brick and mortar
retail stores, and customers buy items in bulk as their purchases are comprised of groceries, which
are perishable goods. On the other hand, Amazon customers purchase items selectively (often one
or two at a time), and the delivery time may add to the DSI value. As Walmart cannot afford to retain
perishable items in its inventory for long, it has a relatively lower DSI value compared to Amazon,
which sells a very diversified variety of goods that remain in its warehouses for a longer period.

What Is a Dividend Payout Ratio?

The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders
relative to the net income of the company. It is the percentage of earnings paid to shareholders in
dividends. The amount that is not paid to shareholders is retained by the company to pay off debt or
to reinvest in core operations. It is sometimes simply referred to as the 'payout ratio.'

The dividend payout ratio provides an indication of how much money a company is returning to
shareholders versus how much it is keeping on hand to reinvest in growth, pay off debt, or add to
cash reserves (retained earnings).

KEY TAKEAWAYS

The dividend payout ratio is the proportion of earnings paid out as dividends to shareholders,
typically expressed as a percentage.
 Some companies pay out all their earnings to shareholders, while some only pay out a portion of
their earnings. If a company pays out some of its earnings as dividends, the remaining portion is
retained by the business. To measure the level of earnings retained, the retention ratio is calculated.

Several considerations go into interpreting the dividend payout ratio, most importantly the
company's level of maturity. A new, growth-oriented company that aims to expand, develop new
products, and move into new markets would be expected to reinvest most or all of its earnings and
could be forgiven for having a low or even zero payout ratio.

What the Dividend Payout Ratio Tells You

Several considerations go into interpreting the dividend payout ratio, most importantly the
company's level of maturity. A new, growth-oriented company that aims to expand, develop new
products, and move into new markets would be expected to reinvest most or all of its earnings and
could be forgiven for having a low or even zero payout ratio. The payout ratio is 0% for companies
that do not pay dividends and is 100% for companies that pay out their entire net income as
dividends.

On the other hand, an older, established company that returns a pittance to shareholders would test
investors' patience and could tempt activists to intervene. In 2012 and after nearly twenty years
since its last paid dividend, Apple (AAPL) began to pay a dividend when the new CEO felt the
company's enormous cash flow made a 0% payout ratio difficult to justify.1 2 Since it implies that a
company has moved past its initial growth stage, a high payout ratio means share prices are unlikely
to appreciate rapidly.

Dividend Sustainability

The payout ratio is also useful for assessing a dividend's sustainability. Companies are extremely
reluctant to cut dividends since it can drive the stock price down and reflect poorly on
management's abilities. If a company's payout ratio is over 100%, it is returning more money to
shareholders than it is earning and will probably be forced to lower the dividend or stop paying it
altogether. That result is not inevitable, however. A company endures a bad year without
suspending payouts, and it is often in their interest to do so. It is therefore important to consider
future earnings expectations and calculate a forward-looking payout ratio to contextualize the
backward-looking one.

Long-term trends in the payout ratio also matter. A steadily rising ratio could indicate a healthy,
maturing business, but a spiking one could mean the dividend is heading into unsustainable
territory.
 The retention ratio is a converse concept to the dividend payout ratio. The dividend payout ratio
evaluates the percentage of profits earned that a company pays out to its shareholders, while the
retention ratio represents the percentage of profits earned that are retained by or reinvested in the
company.

Dividends Are Industry Specific

Dividend payouts vary widely by industry, and like most ratios, they are most useful to compare
within a given industry. Real estate investment partnerships (REITs), for example, are legally
obligated to distribute at least 90% of earnings to shareholders as they enjoy special tax
exemptions.3 Master limited partnerships (MLPs) tend to have high payout ratios, as well.

Dividends are not the only way companies can return value to shareholders; therefore, the payout
ratio does not always provide a complete picture. The augmented payout ratio incorporates share
buybacks into the metric; it is calculated by dividing the sum of dividends and buybacks by net
income for the same period. If the result is too high, it can indicate an emphasis on short-term
boosts to share prices at the expense of reinvestment and long-term growth.

Another adjustment that can be made to provide a more accurate picture is to subtract preferred
stock dividends for companies that issue preferred shares.

Dividend Payout Ratio Example

Companies that make a profit at the end of a fiscal period can do a number of things with the profit
they earned. They can pay it to shareholders as dividends, they can retain it to reinvest in the
business for growth, or they can do both. The portion of the profit that a company chooses to pay
out to its shareholders can be measured with the payout ratio.

For example, on November 29, 2017, The Walt Disney Company declared a $0.84 semi-annual cash
dividend per share to shareholders of record December 11, 2017, to be paid January 11, 2018.4 As

of the fiscal year ended September 30, 2017, the company's EPS was $5.73.5 Its payout ratio is,
therefore, ($0.84 / $5.73) = 0.1466, or 14.66%. Disney will pay out 14.66% and retain 85.34%.