Cautions when using working capital metrics to assess firms' financial health.

Ammons, Janice L. ; Gosman, Martin L.

CASE DESCRIPTION

The primary subject matter of this case explores expectations regarding short-term liquidity across different industries. Secondary issues examined include working capital management and signals of working capital efficiencies. The case requires students to interpret varying working capital and liquidity ratio levels across companies. This case has a difficulty level of two, three, or five; the case is appropriate for financial accounting principles, introductory financial management, intermediate accounting, and introductory financial accounting for MBAs. This case is designed to be taught in one hour of class time and is expected to require one hour of outside preparation by students.

CASE SYNOPSIS

Using data from Bon Ton Stores, TJX Companies, Wal-Mart Stores, Brinker International (Chili's) and Southwest Airlines, students learn about basic liquidity analysis. Students will observe significant differences in key liquidity metrics both within and across industries. Students will consider the overall liquidity positions of the firms by comparing their working capital levels and their current ratios. Students will identify the driver of the differences in the current and quick ratios, and will explore issues in managing working capital. In the process, they will uncover some surprising findings. Some working-capital metrics may look good while hiding deficiencies that can be revealed by further analysis. Similarly, working-capital metrics may look bad, but further digging uncovers efficiencies. The case also highlights the interesting tension that exists between a lender's perspective about liquidity (more is better) versus a company's desire to increase profitability, which necessitates efficiently managing its working capital.

INSTRUCTORS' NOTES

Recommendations for Teaching Approaches

The case features non-manufacturing firms since these are typically the focus of introductory accounting courses. The case can be used at the undergraduate level in introductory financial accounting or when discussing liquidity analysis in intermediate accounting. The case can also be used early in an introductory financial accounting class for MBAs.

The case could be assigned after having briefly discussed the basic liquidity metrics during a class meeting or after having assigned a relevant reading from a textbook. Students should be familiar with accounting for accounts receivable, inventory, prepaid expenses, accounts payable, and unearned revenue. Students should be able to distinguish current assets from long-term assets and current liabilities from long-term liabilities (elements of a classified balance sheet).

Instructors can proceed through the six case questions in numerical order or alter the sequence. However, the last question builds on answers to some of the earlier questions. Depending on the course level, time constraints, or topic preferences, instructors can also eliminate questions. An extension to this case is presented at the conclusion of these instructors' notes. It can be used to introduce students to the ratio of operating cash flow to average current liabilities, a lesser known, but useful short-term-liquidity metric. The instructor can direct students to the SEC's EDGAR website to gather data necessary to see how seven identified pairs of peer retailers fared when measured on this metric vis-a-vis the current ratio.

To facilitate answering the questions, the financial data contained in Table 1 of the case are repeated below. Balance sheet data are as of year-end unless labeled as an average for the year.

QUESTIONS FOR DISCUSSION (WITH SUGGESTED ANSWERS)

1. Despite having $363 million of working capital at F2010 year-end and a 1.88 current ratio that is the highest among the Table 1 firms, Bon Ton was included in a Forbes list of 10 retailers flirting with trouble (Hawkins, 2010). Which data in Table 1 suggest that this retailer's liquidity position was not as favorable as it initially seemed?

Because the current ratio and the working capital amount can create an illusion of favorable liquidity when none may exist, many analysts also calculate the quick ratio. As seen in Table 1, Bon Ton's quick ratio was the lowest among the five firms. The firm went from having the highest current ratio to the lowest quick ratio because 88% of its current assets are tied up in inventory. Perhaps its impressive working capital amount results from the retailer having difficulty in selling its inventories. In comparison, inventory represented 54% and 70% of current assets for TJX and Wal-Mart, respectively.

2. Which ratios could help an analyst appraise the liquidity of Bon Ton's inventory as compared to that for TJX and Wal-Mart? Explain whether relatively high or low values on these metrics would suggest less liquidity risk.

An analyst could compare the three firms' inventory turnover ratios (cost of goods sold divided by average inventory). Inventory turnover indicates the number of times during the period that a firm sells its average balance of inventory. The higher the inventory turnover ratio, the lower the liquidity risk. Similarly, the analyst could compare the average days in inventory, also known as the days' sales in inventory, (365 days divided by the inventory turnover). The lower the average days in inventory, the lower the liquidity risk because inventory is held for a shorter period of time. The current ratio is thus a more accurate indicator of liquidity if a firm has a low average days in inventory. Alternatively, an analyst is likely to place less reliance on the current ratio and more reliance on the quick ratio for firms with slow-moving inventory.

As seen in Table 2, it takes Bon Ton 132 days to sell its average balance of inventory which, respectively, is 72 and 92 days longer than it takes TJX and Wal-Mart. It takes Wal-Mart less than a month and one-half to sell its average balance of inventory. Some of this difference is due to the different composition of merchandise inventories between Wal-Mart and the two other firms. Analysts would expect that Wal-Mart's inventory turnover would exceed Bon Ton's because Wal-Mart sells many food products. However, as is the case for Bon Ton, TJX does not stock food products and yet its inventory turnover is more than twice that of Bon Ton's.

Wal-Mart also uses technology and its power within its supply chain to achieve efficiencies that minimize the amount of inventory it carries. Wal-Mart maintains tight inventory control through its supply-chain management. Given its economic muscle, Wal-Mart achieves many concessions that transfer risk from Wal-Mart to its suppliers. Wal-Mart accelerates delivery times, getting suppliers to replenish inventory frequently. Some speculate that Wal-Mart will eventually use its technology for scan-based trading, in which manufacturers own each product until Wal-Mart sells the item (Hays, 2004). This would further lower reported inventories on Wal-Mart's balance sheet.

3. What contributed to Wal-Mart's negative working capital of $6.6 billion and how can a firm survive, let alone thrive, with such an excess of current liabilities over current assets?

As noted above, Wal-Mart has taken the lead among retailers in achieving inventory efficiencies. At the same time, it has used its power over suppliers to increase its days' purchases in accounts payable. This combination of better inventory management and accounts payable stretching has allowed the firm to simultaneously reduce a major current asset while increasing a major current liability. The combined reductions in its working-capital investment that Wal-Mart achieved through carrying less inventory and taking longer to pay suppliers was measured in a 2005 study. It was estimated there that Wal-Mart achieved a 117% reduction in its working-capital amount over the 1995 to 2003 period by reducing its days' sales in inventory and increasing its days' purchases in accounts payable compared to their 1995 levels (Gosman and Kohlbeck, 2005). The study reported that Wal-Mart's 2003 working capital of a negative $2.4 billion would have been a positive $14.0 billion had it not achieved efficiencies over that 8-year period.

A firm can survive with little or no working capital as long as it has large, steady inflows of cash from operations. As seen in Table 1, Wal-Mart's cash from operations exceeded $23 billion in Fiscal 2010.

4. Explain why it is not surprising that the two Table 1 firms with the smallest differences between their current ratios and quick ratios are Brinker and Southwest Airlines.

Current and quick ratios differ significantly from each other only when a sizable portion of the firm's current assets are in the form of inventories. Restaurant businesses and airlines require relatively low inventory as compared to retail department stores such as Bon Ton, TJX, and Wal-Mart. Restaurants maintain low inventory because food items are perishable. Airlines have always had low inventory levels and with their reduced food offerings on flights, you could say that it now "amounts to peanuts."

5. How might the composition of current liabilities at Southwest Airlines contribute to low current and quick ratios?

Southwest Airlines has a significant current liability in the form of unearned ticket revenue from customers paying in advance of flights. This liability will be satisfied as the customers fly (i.e., when the service is provided). While these obligations increase current liabilities in the denominator of both the current and quick ratios, they will not require significant incremental cash for settlement of the obligation. All other things being equal, the presence of sizable unearned revenue means that current and quick ratios can be expected to be lower and still be adequate.

6. Summarize factors that should affect one's assessment of the adequacy of a firm's investment in working capital and the level of its liquidity ratios.

(1) The extent to which the line of business does not require large inventories.

Airlines and restaurants carry less inventory than department stores, and thus they would be sufficiently liquid with a lower current ratio than department stores would require. In fact, in light of these firms' insignificant inventory amounts, the adequacy of their current ratios is best judged by examining desired threshold levels for quick ratios.

(2) Receivable and payable management (the speed of the cash cycle).

The operating cycle is the sum of the average days in inventory and the average collection period. In general, the shorter the operating cycle, the lower the necessary investment in working capital. By minimizing the number of days a firm holds inventory until sale and/or by quickly converting sales into cash, a firm can be liquid with less working capital.

The longer that a firm is able to stretch its payables, the lower the minimum investment needed in working capital. For example, if a firm sold goods in 40 days like Wal-Mart does and had very few accounts receivable, then so long as it could negotiate credit terms from its suppliers that were not far from 40 days, there would be less need for alternate sources of financing in order to pay suppliers for the inventory purchases. Their customers, in effect, could be paying their suppliers. This creates working capital efficiencies, minimizing the level of working capital needed in order to satisfy short-term obligations as they become due.

Bon Ton suffers here relative to Wal-Mart because Bon Ton is taking 92 more days to sell its inventory. In addition, it is not in as strong a position to negotiate longer payment terms with its suppliers. Thus, Bon Ton has a much greater need to look for other sources to finance its purchases of inventory, whereas Wal-Mart can essentially delay paying suppliers until close to when it has collected cash from the sale of that inventory to customers! Increasing the speed of a cash cycle through inventory and accounts payable management allows firms to carry less working capital.

(3) The extent to which the firm's current liabilities do not require significant incremental cash outflows.

Like Southwest Airlines, any business that typically receives significant amounts of cash in advance for future goods or services should have lower thresholds for adequate working-capital levels and current and quick ratios. Examples would include newspaper and magazine publishers, theater groups, and cruise lines.

Extension

Instructors who wish to consider how Bon Ton would compare to TJX and Wal-Mart on an alternative liquidity measure could introduce the ratio of operating cash flows to current liabilities, calculated as follows:

Operating cash flow to current liabilities ratio = Cash flow from operations/Average current liabilities

This ratio recognizes that successful firms do not liquidate their current assets to pay their current liabilities, but instead use operating cash flow for that purpose. Some research suggests that a level of 40% or higher on this ratio often presents itself for a healthy retailer (Casey and Bartczak, 1984).

Operating cash and average current liabilities are from Table 1. Interestingly, as shown in Table 3, both TJX and Wal-Mart are above 40% on this financial measure and Bon Ton, the firm with the highest current ratio, was below 40%.

Instructors who wish to pursue this point further could direct students to the SEC's EDGAR database to gather data necessary to make the following comparisons for peer retailers: Table 4: Comparison of Current Ratio and Operating Cash Flow to Current Liabilities for Peer Retailers Fiscal Year 2010 Line of Business Retailer Current Operating Cash Ratio Flow to Current Liabilities Jeweler Zale 1.99 14% Blue Nile 1.34 44% Pharmacy Rite Aid 1.82 17% Walgreen Co. 1.60 53% TV and Electronics Conn's 3.00 -15% Best Buy 1.21 13% Restaurant Denny's 0.69 42% Frisch's 0.36 94% Women's Clothing Christopher & Banks 2.86 18% AnnTaylor Stores 1.95 59% Supermarket Winn-Dixie Stores 1.36 26% Publix Super Markets 1.37 111% Office Supplies Staples 1.51 36% Office Depot 1.32 8%

For the first five comparisons included in Table 4, the retailer with the higher (often much higher) current ratio had the lower (often much lower) ratio of operating cash flow to current liabilities. And three of the retailers with impressive current ratios--Zale, Rite Aid, and Conn's--were, like Bon Ton, included in a Forbes list of 10 retailers flirting with trouble (Hawkins, 2010). In the sixth pairing, two supermarkets with practically identical current ratios had, nevertheless, dramatically different ratios of operating cash flow to current liabilities. In the last comparison, Staples' edge over Office Depot in terms of the current ratio understated the magnitude of the former's advantage on the operating-cash-to-current-liabilities metric.

Given that current liabilities are more likely to be paid out of operating cash flow than current assets, the current ratio provides only partial insight into retailers' ability to meet their short-term obligations. In four of the seven pairings shown in the above table, retailers that seemed to be awash in liquidity--as measured by a current ratio of 1.82 or higher--were seen in a much different light when measured by their ratios of operating cash to current liabilities, which ranged from -15% to +18%. Clearly the ratio of operating cash flow to current liabilities should represent an additional arrow in the quiver of the analyst as he/she assesses a firm's ability to meet its short-term obligations.

REFERENCES

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Janice L. Ammons, Quinnipiac University

Martin L. Gosman, Quinnipiac University Table 1: Selected Financial Data--Fiscal Year 2010 Bon Ton Stores, TJX, Wal-Mart, Brinker International, and Southwest Airlines Company BON TON TJX WAL-MART Line of business Discount Discount Discount Department Department Department Store Store Store Quick assets $16,339,000 $2,018,159,000 $12,484,000,000 Inventory $682,324,000 $2,765,464,000 $36,318,000,000 Current assets $777,081,000 $5,099,527,000 $51,893,000,000 Current $413,871,000 $3,133,121,000 $58,484,000,000 liabilities Working Capital $363,210,000 $1,966,406,000 ($6,591,000,000) Current ratio 1.88 1.63 0.89 Quick (acid-test) 0.04 0.64 0.21 ratio Net sales $2,980,479,000 $21,942,193,000 $418,952,000,000 Cost of goods $1,860,182,000 $16,040,461,000 $315,287,000,000 sold Cash flow from $141,135,000 $1,976,481,000 $23,643,000,000 operations Average inventory $670,861,500 $2,648,891,000 $34,515,500,000 Average current $406,974,500 $3,014,053,500 $57,013,500,000 liabilities Company BRINKER SOUTHWEST (CHILI'S) Line of business Restaurant Airline Quick assets $389,764,000 $3,733,000,000 Inventory $26,735,000 Not applicable Current assets $501,067,000 $4,279,000,000 Current $449,877,000 $3,305,000,000 liabilities Working Capital $51,190,000 $974,000,000 Current ratio 1.11 1.29 Quick (acid-test) 0.87 1.13 ratio Net sales $2,858,498,000 $12,104,000,000 Cost of goods $816,015,000 Not applicable sold Cash flow from $297,402,000 $1,561,000,000 operations Average inventory $30,290,000 Not applicable Average current $434,189,500 $3,000,000,000 liabilities Table 2: Retailers' Inventory Ratios Fiscal Year 2010 Bon Ton TJX Wal-Mart Stores Cost of goods $1,860,182,000 $16,040,461,000 $315,287,000,000 sold Average $670,861,500 $2,648,891,000 $34,515,500,000 inventory Inventory 2.77 times 6.06 times 9.13 times turnover Average days 132 days 60 days 40 days in inventory Table 3: Retailers' Operating Cash Flow to Current Liabilities Fiscal Year 2010 Bon Ton TJX Wal-Mart Stores Cash flow from $141,135,000 $1,976,481,000 $23,643,000,000 operations Average current $406,974,500 $3,014,053,500 $57,013,500,000 liabilities Operating cash flow 35% 66% 41% to current liabilities ratio