GF530 Unit 7 Siding Maker Cash Conversion Analysis Example

Earnings Rising, Cash Falling: A Unit 7 Cash Conversion Analysis of a Siding and Trim Maker

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Purdue University Global

GF530: Financial Statement Analysis

Unit 7 Cash Conversion Analysis

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[Date]

The company, its customers and every figure are composite and illustrative, in millions of dollars; the articles and textbook cited are real.

The Company

The company makes vinyl siding, trim and window components sold through lumber dealers and two national home improvement chains. Its revenue grew from 450 to 485 to 520 over three years, and net income rose from 42 to 47 to 53. Shareholders were told margins had held steady. All amounts are in millions of dollars.

Measure 1: Operating Cash Flow Against Net Income

Operating cash flow was 51, 44 and 31. As a share of net income, that is 1.21, 0.94 and 0.58. A healthy manufacturer usually reports operating cash flow above net income, because depreciation is a non-cash charge. A ratio well below one means income is being recorded faster than cash is arriving.

Measure 2: Free Cash Flow Conversion

Capital spending was 12, 14 and 15. Subtracting that spending from operating cash flow leaves free cash flow of 39, 30 and 16. As a share of net income: 0.93, 0.64 and 0.30. By the third year, less than a third of reported earnings was available to pay down debt or return to shareholders.

Measure 3: Receivable Days

Receivables rose from 50.5 to 69.1 to 89.8 while revenue grew far more slowly. Measured against revenue, collection stretched from 41 days to about 52 and then 63. The revenue note explains why: two years ago the company agreed to extend payment terms for the two home improvement chains from 45 to 75 days in exchange for wider shelf placement.

Measure 4: Inventory Days

Inventory rose from 61.4 to 74.7 to 89.2. Against cost of goods sold of 320, 345 and 370, inventory days lengthened from 70 to 79 to 88. Management's discussion attributes part of the build to buying resin ahead of an expected price increase and part to stocking additional colors for the chains.

The Bridge for the Latest Year

Starting from net income of 53:

1. Add depreciation and amortization: 14, giving 67.

2. Subtract the increase in receivables: 20.7, giving 46.3.

3. Subtract the increase in inventory: 14.5, giving 31.8.

4. Add the increase in payables: 2.4, giving 34.2.

5. Subtract other working capital changes: 3.2, giving operating cash flow of 31.0.

Receivables and inventory together absorbed 35.2 of cash, more than the entire difference between income plus depreciation and the cash the company actually collected.

The company did not earn less cash than before because it became less profitable; it earned the same margins but financed its two largest customers and its own resin stockpile, so the earnings were real but the cash was lent out.

Why It Matters

In a study of thousands of firm-years, Sloan (1996) found that the accrual portion of earnings, the part sitting in receivables, inventory and similar accounts, is less likely to recur than the cash portion, and that investors were slow to price that difference. A broader review of earnings quality measures reaches a similar view: the gap between income and cash is one of the most reliable signs that reported earnings overstate sustainable performance (Dechow et al., 2010). This does not mean the company's income is false. It means a larger share of it depends on collecting from the chains and selling the stockpiled inventory.

Temporary or Permanent?

The inventory build looks temporary. A resin purchase made ahead of a price increase should unwind within a year, and the notes show the company has already reduced purchase commitments. The receivables look permanent. The 75-day terms are written into the chains' supply agreements, which run three more years, and the chains are unlikely to give them back. In effect, the longer terms are a price cut paid in financing rather than in the invoice. Receivables now sit about 31 above what 41-day collection would require, and at the company's borrowing rate of about 6.5 percent carrying them costs roughly 2.0 a year before tax, a cost that does not appear anywhere on the income statement (Penman, 2013).

What to Ask Management

Three questions would sharpen the analysis. First, how much of the receivable increase sits with the two chains and how much with lumber dealers, since dealer balances carry more credit risk than balances owed by national retailers? Second, has the company considered selling the chains' receivables to a bank, which would bring cash back at a known discount and make the financing cost visible? Third, how much of the resin stockpile was bought at prices above today's, since a fall in resin prices would leave the company holding costly inventory and squeeze margins when it is used? The answers would show whether the cash gap is a deliberate commercial choice or a drift that management has not fully priced.

Conclusion

Reported earnings growth of 26 percent over two years came with a fall in free cash flow of nearly 60 percent. The inventory part should reverse; the receivables part is a lasting change in how the company is paid. An analyst should treat roughly 2.0 a year as a hidden financing cost when comparing margins with peers whose customers pay on standard terms.

References

Dechow, P., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2-3), 344-401. https://doi.org/10.1016/j.jacceco.2010.09.001

Penman, S. H. (2013). Financial statement analysis and security valuation (5th ed.). McGraw-Hill.

Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289-315.