Retailers Accounting 101 (A Conceptual Overview)

Investing in Retail:  Understanding the Cash Conversion Cycle (CCC)

One of the best ways to distinguish excellent retailers from average or below average ones is to look at their cash conversion cycles.

The CCC tells us how quickly a firm sells its goods (inventory), how fast it collects payments for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns).

The best case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier.

Wal-mart is one of the best in the business at this:  70% of its sales are rung up and paid for before the firm even pays its suppliers.


COMPONENTS OF CCC

INVENTORY TURNS
Looking at the components of a retailer's cash cycle tells us a great deal.

A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favour.

This leads to excess inventory, clearance sales, and usually declining sales and stock prices.


RECEIVABLES TURNS
Days in receivables is the least important part of the CCC for retailers because most stores either collect cash directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price.

Retailers don't really control this part of the cycle too much.

However, some stores, have brought attention to the receivables line because they've opted to offer customers credit and manage the receivables themselves.  

The credit card business is a profitable way to make a buck, but it is also very complicated, and it is a completely different business from retail.

Be wary of retailers that try to boost profits by taking on risk in their credit card business because it is generally not something they  are good at.


PAYABLES TURNS
If days in inventory and days in receivables illustrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers.

It is also a great gauge for the strength of a retailer.

Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they are one of the few (if not the only) games in town.

The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retail has a huge advantage when ordering inventory:  It can push for low prices and extended payment terms.

Extending payment terms to their suppliers allow the retailers to hold on to its cash longer and to reduce short-term borrowing needs; effectively increasing the retailers' operating cash flows .



Additional Notes:
In retail and consumer services, most economic moats for the sector are extremely narrow, if they exist at all.

Therefore, not surprisingly, you don't find a ton of great long-term stock ideas in retail and consumer services.

The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'.

It can do this by offering unique products or low prices.

Although you can do well buying high quality specialty and clothing retailers when the industry sees one of its periodic sell-offs, very few of these kinds of firms make great long-term holdings.

Investor's Checklist: Consumer Services

Most consumer services concepts fail in the long run, so any investment in a company in the speculative or aggressive growth stage of the business life cycle needs to be monitored more closely than the average stock investment.

Beware of stocks that have already priced in lofty growth expectations.  You can make money if you get in early enough, but you can also lose your shirt on the stock's rapid downslide.

The sector is rife with low switching costs.  Companies that establish store loyalty or store dependence are very attractive.  Tiffany's is a good example; it faces limited competition in the retail jewelery market.

Make sure to compare inventory and payables turns to determine which retailers are superior operators.  Companies that know what their customers want and how to exploit their negotiating power are more likely to make solid bets in the sector.

Keep an eye on those off-balance sheet obligations.   Many retailers have little or no debt on the books, but their overall financial health might not be that good.

Look for a buying opportunity when a solid company releases poor monthly or quarterly sales numbers.  Many investors overreact to one month's worth of bad same-store sales results, and the reason might just be bad weather or an overly difficult comparison to the prior-year period.  Focus on the fundamentals of the business and not the emotion of the stock.

Companies also tend to move in tandem when news comes out about the economy.  Look for a chance to pick up shares of a great retailer when the entire sector falls - keep that watch list handy.  


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey


Read also:
Investor's Checklist: A Guided Tour of the Market...

For every Wal-Mart, there's a Woolworth's

For every Wal-Mart, there's a Woolworth's

Sticking to a valuation discipline is tough for many people because they're worried that if they don't buy today, they might miss the boat forever on the stock.

That's certainly a possibility - but it's also a possibility that the company will hit a financial speed bump and send the shares tumbling.

The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.

As for the few that just keep going straight up year after year - well, let's just say that NOT MAKING is a lot painful than LOSING money you already have.

For every Wal-Mart, there's a Woolworth's.