Candy Cash Flow: The Secrets To See’s Candy

Charles A. See, a salesman from Ontario, opened the first See’s Candy shop in Pasadena, Calif. in 1921, with his mother Mary See. Exactly 50 years later Warren Buffett picked up his first See’s candy and gave it a try. After hearing about See’s from his West Coast colleague Charlie Munger (in 1971), an eternal synergy blossomed with a blue chip buy-out of See’s Candy the following year.

“Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.”

It is no mystery that See’s Candy is one of the most profitable and important investments Buffett has made in his career. When Buffett purchased See’s in 1972, he and Charlie Munger had said they would not have been willing to pay one cent more than $25 million using the float of blue chip stamps to purchase the shares.

Introduction

See’s Candy is a textbook example of a magnificent business with a continually widening moat, characterized as above average return on assets, incredible return on invested capital, pricing power and a negative operating cycle. These effects are due to superb management (See’s family, Chuck Huggins and now Brad Kinstler), high customer captivity, low to non-existent capex (and maintenance capex) and proficiencies in industry jousting (game theory/prisoners dilemma). 

Buffett realized all of the following when he made his purchase for $25 million, $17 million of which was economic goodwill or what others refer to as intangible “brand equity.” He demonstrates this knowledge when talking (over the years and in the quote below) about the Pavlov association of both Coca-Cola and See’s Candy.

Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, ‘Honey, this year I took the low bid.’ And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.”

The Growth & Valuation 

See’s had roughly $4 million pre-tax profits, $2 million after tax earnings, $30 million in sales and $8 million in tangible assets at the time of acquisition. Buffett had agreed to pay roughly 12.5x earnings or 6.25x pre-tax, not astronomical considering what was to come from the candy cash flow machine. Ironically, he mentioned he and Munger would have walked away if the price were even a penny higher, likely a huge mistake.

See’s Candy 1972-2007

Year Tangible Assets Earnings ROA
1972 $8 Million $2 Million 25%
1983 $20 Million $13 Million 65%
2007 $40 Million $82 Million 205%

We now know with hindsight that See’s grew sales volumes relatively slow, from 16 million pounds of candy in 1972 to 31 million pounds in 2007, only annual growth of roughly 2%. But over the same time sales grew from 30 million to 383 million, roughly a 7.5% CAGR. The discrepancies between the two growth rates can be attributed to the continual rise in price per pound (5.5% annually) and directly dropping to pre-tax earnings (all else equal).

“When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.”

Provided Buffett could see the future, how much would a rational person be willing to pay in 1972 for $4 million pre-tax earnings with 7.5% growth in perpetuity? Assuming a required return of 10% we would arrive at a present value of roughly 160 million [4,000,000 / (0.10-0.075)] or almost 6.5x what Buffett was willing to pay. If there were no growth, the present value (in 1972) would be $40 million, a large difference thanks to pricing power (growth).

Widening the Moat

See’s boasted something uniquely similar with other successful investments of Berkshire (BRK.A)(BRK.B), that being, a negative operating cycle, customer captivity, pricing power, above average ROIC/ROE/ROA and excellent management.

  • Negative Operating Cycle

Essentially, See’s was able to sell the majority of the annual volume in the months of December and February (Christmas and Valentines Day) for cash, utilizing short-term debt and minimizing overhead. At the time, due to the suspected length of accounts payable being around 30 to 60 days (other than wages) and accounts receivable being eliminated due to immediately receiving cash (or an equivalent), a seasonally negative operation cycle was born and a very short-term float present for Buffett to utilize.

“Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.”

  • Customer Captivity

Customer captivity can be the product of many different variables at work within a business. Briefly speaking, it is the condition of being imprisoned or confined to a particular brand, product or service due to either qualitative/psychological factors; a monopoly or oligopoly being present, customer satisfaction, or opportunity costs/switch costs to the customer. Customer captivity is what leads to the ability to gradually raise prices (pricing power) at a pace faster than inflation, because the customer is “confined.” There is much to be said about customer captivity and the discussion must be kept short. Psychological factors can be a wide swath of biases and influences but the most notable are the effects of association and habit.

Association and Habit (refer to Pavlov and his dog) are no strangers to Coca-Cola (KO), as Coke targets being associated with happiness and the experiences that are had while drinking Coke. The more the same coke or chocolate is consumed the more likely the customer is to re-purchase due to out implicit/procedural learning styles. Much like smokers who do not change brands. See’s Candy is a similar scenario, meaning that during each Christmas season and every Valentines Day, men across the country have become accustom to buying chocolate from a particular company (in this case See’s) and will pay the price required, due to the association of memorable times, the brand imagery (think Starbucks) and for fear their lady may not be satisfied if they cheap-out this year. The all encompassing “brand strength” would be included in psychological factors.

See’s thought and still thinks local, originally servicing a niche market and organically growing slowly to other areas around the world, exploiting the effects of habit and association. By thinking local, delivery times were kept minimal, (ensuring product quality remained high) existing factories, warehouses and equipment (assets) were being utilized efficiently and brand familiarity was built.Most important of all, CUSTOMER SATIFCATION came first. Today 110 of its 211 stores are in California, and “thinking local” is still deeply engraved in their business DNA.

In my early days as a manager I, too, dated a few toads. They were cheap dates – I’ve never been much of a sport – but my results matched those of acquirers who courted higher-priced toads. I kissed and they croaked. After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous). Said the pro: “Practice doesn’t make perfect; practice makes permanent.” And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.”

  • Honest & Integral Management

It is always impossible to put a numerical figure on great management, as Buffett states in his famous quote, it is very hard to overpay a truly remarkable CEO albeit he also notes the species is rare. I am sure having Chuck Huggins and now Brad Kinstler is and has been a huge advantage for See’s Candy. Huggins regularly inspected plants, ensuring quality was high, acknowledging employees on a first name basis (names were also stitched to lab coats) and encouraging employees to eat as much candy as they like. Kinstler picked up where Huggins left off, looking to expand to the east coast in the coming years. Both CEOs were long-time Berkshire family members and have the Berkshires interests in heart/mind. Both CEOs always put customer satisfaction and product quality first and foremost on their minds.

  • Above Average ROIC & ROA

The astronomical ROIC and ROA are both thanks to a combination of low working capital, low capex and low maintenance capex. These favorable business characteristics were a by-product of an industry that was not subject to rapid change, had slow per-capita consumption growth, disproportionate seasonal sales, strong pricing power and non-cannibalizing competitors.

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.”

The competitors within the industry realized that rather than cannibalize on the slow (a meager 2% annual per-capita consumption) growth by competing on price they would be better off collectively(albeit non-collusive) raising prices annually like true prisoners dilemma champions.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to ‘be fruitful and multiply’ is one we take seriously at Berkshire).”

  • Conclusion

In “Security Analysis” Ben Graham wrote, “It may be pointed out that under modern conditions the so-called “intangibles,” e.g. good- will or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities. Furthermore, when conditions are favorable the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore grow more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.”

Buffett was lucky to learn the value of intangibles not correctly reflected in the financial statements, through his acquisition of See’s Candy. Buffett once said, “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” With a tangible book value of $7 million his probable loss would have been 72%. The probable gain could be quickly conceptualized by taking 5% expected growth (EBIT / k –g) or 4,000,000 / 0.10 – 0.5 = 80,000,000 or 220% probable gain. Given the range and numbers of probabilities Buffett may have assigned at the time, I will take a 30/70 weight on the two single variables leading to an expected probable gain of 132%.

This is not an exact science and uses quick heuristics, but I am led to believe these are the focuses of Warren Buffett and how he analyzes companies. Regardless of how undervalued he believed See’s Candy to be, it was a great investment and likely produced the cash flow ($1.35 billion) for other great investments along the way, proving the economic value to be higher, in terms of opportunity cost. See’s Candy is the perfect business to emulate when looking for investment ideas, and I think Buffett relized that as other famous investments came a short period after. It is also fair to remeber Buffett and Munger may have cast a Pavlovian effect onto See’s, enabling sales to materialize that may have not otherwise.

“We have made a lot more money out of See’s than shows from the earnings of See’s, just by the fact that it’s educated me, and I’m sure it’s educated Charlie too. It’s one thing to own stock in a Coca-Cola or something, but when you’re actually in the business of making determinations about opening stores and pricing decisions, you learn from it.

Further Reading

http://www.berkshirehathaway.com/letters/1992.html

http://www.berkshirehathaway.com/letters/2007ltr.pdf

My Favourite Books of 2013

Personal Favorite Books Read in 2013

As the year comes to an end it is time to put together my annual favorites from the last 365 days. I read 48 books this year and am just finishing the 49th “Hatching Twitter” (I would love to hit 50, two short of my one a week goal). There were plenty of great books I have blogged about over the year that were not included on the list for sake of repetition. A good indication a book has resonated with you is that you have recommended it on more than one occasion, you have talked about the ideas on numerous occasions (with numerous people) and that you’re attempting to implement them (or have) into your life.

Also see a quick article: How to Read Intelligently

I will reiterate myself and recommend all of the following books below if you have not read them already and have an interest in business, investing, finance, or accumulation of knowledge in general. The books I have included I would be willing to read multiple times over the course of my life, as depicted by an Oscar Wilde quote “If one cannot enjoy reading a book over and over again, there is no use in reading it at all.” There are numerous others not included that I have re-read and will re-read in the future albeit for the sake of exhaustion they were not included. (None of the books below were published in 2013).

Against the Gods: The Remarkable Story of Risk

By Peter L. Bernstein

(Both Warren Buffett and Charlie Munger recommended this book) This was my favorite book of 2013 (although I read it in December so I am subject to the recency effect). Starting in 1200 and working towards present day, Bernstein examines the fundamental components of risk, finance, and applied mathematics. Brief histories of famous mathematicians, economists and their ideas are examined including Pascal, Fermat, Fibonacci, al-Khowarizmi, Cardano, Galileo, Daniel and Jacob Bernoulli, Graunt, Hailey, De Moivre, Bayes, Gauss, Galton, Poincare, Einstein, Bachelier, Laplace, Keynes, von Neumann, Morgenstern, Markowitz, Tversky, Kahneman, Black, Scholes, and Leibniz. The book is based on mathematics and may not be of much interest to people who do not have a mathematics background or/and an interest in history. An extensive review is availablehere.

Thinking Fast & Slow

By Daniel Kahneman

This book has been very influential on my attitude and life since reading and methodically taking notes on the biases that I had been previously blind to. The basis of the book is what Kahneman calls system one and system two. System one being an implicit system (un-intentional, subconsious, immediate) and system two being an explicit system of thought and rationalization. Prospect theory is a major component of Kahneman’s writing and works over the years; developed from Bernoulli’s utility theory, which is also addressed in Against the Gods. Essentially the majority of people are risk averse and the price they are willing to pay changes based on the reference point (anchoring) or how the option is offered (framed). Amos Tversky was also an enormous influence on the discoveries of decision theory and would have likely shared the Nobel Prize in Economics with Kahneman and shared in writing the book, provided his life was not cut short. The book should be read in doses by anyone with an interest in rationale choices, decision theory, behavioral finance, psychology, economics or a drive to accumulate knowledge, with a pad of paper, a pen and a wide open mind.

The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger

By Marc Levinson

I never thought that I would have become so infatuated with global logistics until I came across this book about the shipping container and brief history of American logistics throughout the 20th century. From the early-unorganized docks and streamliners to massive cargo ships capable of carrying over 16,000 standard 20’ shipping containers. It is an epic documentation of the rise of the shipping container starting with the first re-fitted oil tanker that carried fifty-eight containers from Newark to Houston. Bill Gates had recommended the book in his summer reading list, I promptly picked up a copy and read it front to back. The funny thing about reading is the more you learn, the more you want to learn and this book was no different, sparking my interest in railroad, airline, trucking and shipping logistics around the world. Thanks Bill.

Competition Demystified: A Radically Simplified Approach to Business Strategy

By Bruce Greenwald

Competition Demystified examines the competitive strategies of various [case study] businesses, from Apple, Compaq and IBM to Coors and Anheuser Busch, the book is packed with real world examples. Greenwald focuses on barriers to entry, the prisoners dilemma, the power of thinking local, supply, demand, economies of scale, switch costs, customer captivity, entry/preemption, cooperation, and valuation metrics (briefly). I found numerous tidbits of knowledge that I have filtered into my investment checklist and analytical process.

Antifragile: Things That Gain From Disorder

By Nassim Taleb

A mind bending book that I have read in very small doses (10-20 pages at a time) with deep intellectual thought. It has opened my eyes in an unimaginable way to uncertainty, knowing what you don’t know and admitting it. Taleb also opens our eyes wide to the fallibility of what we think we know, history, academics, and other people of power throughout history. [Amazon Review] Just as human bones get stronger when subjected to stress and tension, and rumors or riots intensify when someone tries to repress them, many things in life benefit from stress, disorder, volatility, and turmoil. What Taleb has identified and calls “antifragile” is that category of things that not only gain from chaos but also need it in order to survive and flourish.

The antifragile is immune to prediction errors and protected from adverse events. Why is the city-state better than the nation-state, why is debt bad for you, and why is what we call “efficient” not efficient at all? Why do government responses and social policies protect the strong and hurt the weak? Why should you write your resignation letter before even starting on the job? How did the sinking of the Titanic save lives? The book spans innovation by trial and error, life decisions, politics, urban planning, war, personal finance, economic systems, and medicine. And throughout, in addition to the street wisdom of Fat Tony of Brooklyn, the voices and recipes of ancient wisdom, from Roman, Greek, Semitic, and medieval sources, are loud and clear.

The AIG Story

by Lawrence Cunningham

A business biography of AIG, crafted by Lawrence Cunningham (The author of The Essays ofWarren Buffett) with Maurice (Hank) Greenberg, ex-CEO of AIG. The AIG Story chronicles the rise and fall of AIG in two sections, during Greenberg’s tenure and after his removal due to attorney general Eliot Spitzer relentless financial re-statment witch hunt through media prosecution. The AIG Story is a reminder that businesses are built on a foundation of the firm’s culture and a few rotten apples can ruin the whole bunch. The culture is dictated by upper managements vision, ideals, ethics, and character, thus The AIG Story taught a valuable lesson of the perils of lack of oversight, regulation, and management driven by the wrong (easily manipulated) incentives. Thanks to the nationalization of AIG they have begun to return to their roots, only after destroying shareholder wealth.

Link

Deadly Derivatives: Warren Buffett Uses The Ones He Understands

Deadly Derivatives: Warren Buffett Uses The Ones He Understands

Warren Buffett famously stated in his 2002 letter to shareholders “Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”The growth over the last 15 years in the derivatives market has been startling, with most retail investors now indulging in directional bets (calls and puts) before earnings as well as volatility selling strategies. Selling volatility was what led to the downfall of LTCM in 1998 and requires knowing two key variables, the price of the underlying asset and the future expected volatility of the asset until expiration (implied volatility). Implied volatility is a more important variable in my opinion for pricing options. (A general heuristic is the lower the IV, the cheaper the option; most assets’ price and volatility have a negative correlation.)

Transcendent Technology Or A Speculative Frenzy?

In recent reports from MarketsandMarkets and Transparency Market Research, authors claimed that the 3-D printing industry as a whole would be the beneficiary of 23% to 28% CAGR until 2020. That sounds fantastic with no additional information, but my Bayesian instincts kicked in after hearing a few additional pieces of information, the first being that the market in 2012 was an estimated $2.2 billion. Taking the highest estimate of 30% for the next seven years, one would arrive at a cumulative 3-D printing market value of $13.8 billion at the beginning of 2020. Although the market research report estimates a market of roughly $8.41 billion by 2021.Goldman and Credit Suisse took offense and published their reports claiming a total market of $10.8 billion by 2021 and that it is very disruptive technology.

The second piece of information I received was that Hewlett Packard (HPQ) as well as General Electric (GE) were both strategically interested in the technology and thought that it could be a big hit for their future businesses (HP has had 3-D printing in production for at least five years, and the technology was invented in 1984). Last time I checked, the industry behemoths are not the innovators and likely using it as a mass appeal strategy. Both have annual revenues of over $100 billion.

The third point is that Whitney Tilson is short ExOne, 3D Systems and VoxelJet. Whitney Tilsonhad the following to say about the 3D Systems, the largest short of the bunch.

Ya can’t make this stuff up! From a friend who met with the CEO of DDD (not some penny stock, but an $8 BILLION company): Avi told me during a 1×1 that “his company is 50% technology, 20% innovation and 30% awesomeness.”

What is the appropriate discount rate to apply to “awesomeness”?

Remember that line – it’s a classic; like Chuck Prince’s infamous: “As long as the music is playing, you’ve got to get up and dance.” The only surprise is that Elon Musk didn’t say it.

DDD is one of so many unbelievably great shorts out there right now. I haven’t written it up (yet), but Citron wrote an excellent report in February entitled, What do a Comb, an Egg Cup, and a Justin Bieber Vibrator Have in Common? The stock is a much better short today, as it’s up 26% since then but the fundamentals are deteriorating and the company lowered guidance in its last earnings report. But that hasn’t deterred the bulls, as it trades within a few percent of its all-time high, at 17.2x REVENUES, 64x trailing EBITDA, and 63x next year’s earnings estimates.”

3D Systems had 2012 sales of 353 million or roughly 16% of the 2012 market share, while Stratasys had $215 million in sales or roughly 10% market share. Now taking even the highest estimates of market value in 2021, the highest CAGR estimates, an assumption market share will not erode to larger and deeper pocketed competitors, we reach roughly $3.5 billion market share (in revenues for 2020) for the two companies mentioned above.

3D Systems and Stratasys have market capitalizations of $7.8 billion and $5.74 billion respectively, or a combined total of 13.54 billion. This equates to 4x estimated 2020 sales (using the ridiculous assumption above) or about 4.7x the 2013 market in its entirety. Yes, those two companies have 26% market share and are worth the [Credit Suisse] estimated 2021 market. I am not having a hallucination; the sum of the parts is being valued more than the projected market as a whole.

I was not around during the early 1900s but if I was, I am sure I would have a taste of nostalgia right now. The auto industry had over 1,800 manufactures in the U.S during the early 1900s, with only three remaining today, two of which have been nationalized at least once. Whitney Tilsoncompared 3D printing to the SegWay and how it was expected to be a breakthrough on the innovation front but was an embarrassing flop.

ExOne (XONE)’s Julian Mitchell said, “We see three key downside risks to consensus sales growth assumptions: (1) uptake of the core technology is liable to be constrained by lack of CAD penetration in Asia (where XONE has higher exposure than peers); (2) there is a need for significant post processing in metals (unlike competing technologies); (3) revenues are highly cyclical, given full exposure to industrial markets and minimal materials ‘tail’ following a system sale.”

Citron was a little more ruthless in their recent report about VoxelJet, calling it a F***ing joke.

Now to compare price to sales, price to earnings, PEG and EV/EBIT between a few 3D printing companies, you be the judge if valuation is fair (N/A means the company is losing money or lack of earnings). I am not recommending shorting any particular company but avoiding the sector as a whole.

Metrics SSYS VJET XONE DDD
Market Cap 5.74 Billion 588 Million 771 Million 7.8 Billion
P/S 11 45.9 22.9 13.7
P/E(TTM) N/A N/A N/A 109.5
PEG N/A N/A N/A 0.6
EV/EBITDA 161 287.62 343 68.7


Tilson I suspect is short 3D systems for liquidity and volatility reasons instead of VJET or XONE.

I could not recommend any of these companies to anyone and they should be avoided. When the party stops these inflated balloons will be the first to pop. When two companies (that have 26% market share) are valued at the entire estimated 2021 market you have a problem, a problem ofrisk seeking versus avoidance and risk that growth does not materialize. When companies are priced beyond perfection it is not my cup of tea. Margin depression, market share loss, lack of industry growth or financing drying up due to cyclicality could cause anyone of these companies to witness a 50% hair cut and still be richly priced.

3D Systems Corporation 10-Y History of P/S Ratio

Dec03 Dec04 Dec05 Dec06 Dec07 Dec08 Dec09 Dec10 Dec11 Dec12
1.18 2.38 2.03 2.05 2.04 1.27 2.26 4.62 3.17 7.26

3D Systems currently has a P/S ratio of 13.7.

We are seeing indications everywhere of a speculative frenzy within the industry. From the proposals of 3D printing ETFs, to short interest as an investment thesis, the sector is littered with folk who can not remember just five and 13 years ago. Ignorance of the past is a root of future imprudence.

The Balance Sheet Walk Through – The Second Step During My Investment Process

The Balance Sheet Walk Through: The Second Step During My Investment Process

“Volatility is a symptom that people have no idea of the underlying value” Jeremy Grantham

Many investors and business owners on the most basic level overlook the balance sheet analysis routinely. It is not apparent how important the balance sheet truly is to business operations until liquidity concerns are front and center, threatening to terminate daily operations, followed by creditors pillaging assets. Intelligent investors from the school ofGraham&Doddsville understand the importance of the financial statements,more specifically the balance sheet, and the story that is being told. Balance sheet analysis comes second only after the idea generation process and is viewed before both the income statement and cash flow statement during my process.

Solvency

The solvency and liquidity ratios of a firm are of integral importance for both the survival of the firm and creditworthiness of future financing (favorable financing terms may lead to a competitive advantage). The solvency ratios that an intelligent investor should focus on are the current ratio, quick ratio, cash ratio, days of working capital, and interval measure. These ratios show the firms ability to pay the bills in the short-term or how long the firm could last with no future cash-inflows.

The current ratio being the most well known of the bunch, is a measure of the difference between assets that can be converted into cash (in one year or under) and bills or liabilities that are due within the next 365 days. The quick ratio is a form of the current ratio with inventories excluded as inventories can be manipulated (bloated), obsolete, damaged, or lost/stolen and inventories are often the most illiquid current asset. The cash ratio or NWC (net working capital) may be of interest to short-term creditors or in times of stress. A low level (ratio or %) of either would show that the company operates on low levels of liquidity. Days of working capital or the interval measure may be of interest, revealing the length a business could operate on a short-term basis due to a potential strike or other disruption of cash inflows.

· Current Ratio = Current Assets / Current Liabilities

· Quick Ratio = (Current Assets – Inventory) / Current Liabilities

· Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

· Days of Working Capital = (Current Assets – Current Liabilities) / (Annual Expenses / 365)

· Interval Measure = Current Assets / Average Daily Operating Costs (excluding interest and depreciation)

At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.” –Warren Buffett

The solvency metrics of a business are of importance but it is generally a good idea to dig deeper into the quality and reliability of cash flows in the income and cash flow statements. An example is a company like P&G operating with negative working capital with 24 billion current assets and 30 billion current liabilities or 0.8 current ratio, but due to the reliability of the conversion of inventory to cash and additional sales (from continuing operations) that may be generated in any given quarter, P&G is able to service this debt with ease. (Some companies may need short-term financing due to seasonality of their business model)

Sources and Uses of Cash

During each quarter or year (actually everyday) a company generates cash as well as uses cash, loosely speaking, an increase in assets or decrease in liabilities/equity is a use of cash while a decrease in assets or an increase in liabilities/equity is a source of cash (the difference being net addition or subtraction to cash). The story is not finished there and balance sheet changes must be viewed in combination with the income statement and cash flow statement over multiple time intervals, if one wishes to reveal what is happening in the company. I personally elect to view a mandatory minimum of three years while ideally viewing 7-10+ years.

Asset Management & Turnover (Efficiency Ratios)

Assuming the company that one is analyzing is not forgoing any additional sales, the higher the inventory turnover ratio the more efficient the company is managing its inventory. The longer thedays’ sales in inventory or lower the inventory turnover ratio the more the company must pay in storage, insurance etc., ultimately lowering the companies gross margins. The average or what is considered normal is roughly 90 days for days’ sales in inventory and if the ratio is higher one should investigate for a number of reasons.

Management could have poor financial management skills by over investing in inventory, some of the inventory could be obsolete or facing markdowns, inventory shrink may be a problem, or hopefully the company is just selling a different product mix. Selling is usually characterized when the product is shipped or the service is performed but that does not tell us the terms of the sale or ability to collect on those terms. Receivables turnover and days’ sales in receivables reveal the ability to collect while payables turnover shows the length it takes to pay. Longer payable periods result in a cash inflow while longer receivable periods result in a cash outflow.

A great business advantage is one where a company uses negative working capital (due to financing abilities) like Cineplex here in Canada. Cineplex has a near monopoly in the movie theatre business (in Canada) with high margins on concession items and a built in competitive advantage based on how the movies are financed. When someone pays to view a movie at Cineplex, they pay for the show immediately before viewing, while Cineplex has an additional 8-12 weeks to pay the production companies, essentially providing a very short-term float and the ability to operate on negative working capital.

The total asset turnover ratio reveals how efficiently the company assets produce cash and should be viewed relative to the fixed asset turnover ratio, enabling an investor to gauge the leverage employed by the company. An investor may also use this information during a scenario analysis/sensitivity analysis; acknowledging fixed costs cannot be forgone, easily.

· Inventory turnover = COGS / Inventory

· Days’ sales in inventory = 365 Days / Inventory Turnover

· Receivables turnover = Sales / Accounts Receivable

· Days’ sales in receivables = 365 Days / Receivables Turnover

· Net working capital turnover = Sales / NWC

· Total asset turnover = Sales / Total Assets

· Fixed asset turnover = Sales / Fixed Assets

It takes much longer for surplus capacity or inventory to be absorbed than the time it takes demand to exceed supply, leading to longer trough periods and shorter periods of prosperity, due to the fixed nature of production assets and the competitive nature of capitalism (When profit margins are high competition is enticed to enter).

Inventory should also be further viewed with a keen eye, taking notice of raw material, WIP, and finished good trends. Excessive finished goods in relation to raw material or WIP may be a sign of surplus inventory, the opposite being true if raw material and WIP levels are increasing relative to finished goods. One should also be aware of seasonal trends that may lead to additional finished goods being produced (mainly in the third quarter).

Financial Leverage

Financial leverage ratios show how indebted the company is as well as the ability to service the longer-term debt commitments. Total debt should include all outstanding lease agreements and other contractual obligations that will eventually be paid. The cash coverage ratio may be used questionably on a long-term basis if maintenance Capex is not subtracted from EBITDA. Buffett used maintenance Capex metaphorically, and in his example he used the food/nutrition of a human as a parable for maintenance Capex. Buffett explained that it is ok to miss a meal or two or even an entire week but if you miss to many meals in a row, you will starve to death. Personally I prefer simply looking at the interest that will be owed both currently and over the life of the business, in relation to operating income.

· Debt to equity = Total Debt / Total Equity

· Equity multiplier = Total Assets / Total Equity

· Times interest earned = EBIT / Interest Expense

· Cash coverage = EBITDA / Interest

When you combine ignorance and leverage, you get some pretty interesting results.” – Warren Buffett

Market Value Ratios

The book value reveals the “net worth” of a company and the theoretical value that an investor would receive upon liquidation. The ratio can be very miss-leading, but also very helpful, depending on the nature of the business as well as past events that are concealed within the accounting entries. Book value is subject to an entirely other post, specifically the fallibility of book value and owners equity. Enterprise value is characterized as Market Value of equity + market value of interest bearing debt + minority interest – cash and equivalents. A low EV/EBITDA ratio may show that the company (depending on reliability of cash flows) is able to support additional debt (private equity buy-out/LBO) and is used as a proxy for a firm’s cash flows and the market value multiple of those cash flows. It is subject to less accounting manipulation thus is more widely used than the P/E ratio by investment bankers and private equity firms.

· B/V = Market Capitalization / Equity

· EV/EBITDA = Market Value of equity + market value of interest bearing debt + minority interest – cash and equivalents / Earnings before income tax, depreciation and amortization.

Questions to Ask (From My Checklist)

Looking out 5 to 10 years, how does the company plan to invest cash that is retained in the business? Can receivables be collected more aggressively, payables more lenient? Is some debt uncollectable? Is exhausted equipment being regularly replaced? Are the debts of the company trending up or down?

What is the expected return on equity, on incremental investment? What are the company’s plans concerning its capital structure over the next five years: Debt/equity, leasing assets, spinning off capital-intensive assets, off-balance sheet financing? Operating leverage: If sales increase by $1 how much will drop to pre-tax income? Is the receivables cycle lengthening? Are the inventory components forecasting a shortage or surplus?

“It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.” – Warren Buffett