4.12 Analyzing Operating Efficiency

A second important driver of growth captured in ROE is the Asset Turnover Ratio.  Total Assets consist of two sub groups: Current Assets and Non-Current Assets.   As a result,

So the Asset Turnover Ratio can be increased if either Current Assets or Non-Current Assets can be trimmed without affecting sales.  We analyze the drivers of Asset Turnover by separately considering Working Capital (a. below) and Operating Leverage (b. below).  This type of decomposition provides insights that are primarily relevant to the “Process Perspective” of the balanced scorecard to the extent that they result from the firm’s investment decision.

Analyzing Working Capital Activity

Ideally, Working Capital is defined in relation to the investment decision, which means that financing and tax related activities should be stripped out of Working Capital (defined as Current Assets minus Current Liabilities).  This leads to eliminating items such as short term debt and the current portion of long term debt as well as deferred tax assets/liabilities. Similarly, we eliminate cash and marketable securities from working capital.  We will return to the role played by these balance sheet items in a later section when we consider liquidity and solvency ratios.

Target’s business strategy is changing with their new initiative called “PFresh” to roll out groceries to the chain’s 1,743 stores (general merchandise and Super-Targets).  This will bring their business strategy closer to Wal-Mart and should improve inventory turnover numbers. 

Working capital, as defined above, consists of:  Accounts Receivable, Inventory and Accounts Payable.  These major components lead to the three major turnover ratios.  The numerator of these turnover ratios is usually defined relative to their closest driver.  For example, Accounts Receivable is driven by Sales on Account and therefore Net Credit Sales is used in the numerator if available otherwise Sales.  However, under historical cost accounting Inventory as measured on the balance sheet is more closely aligned with the Cost of Goods Sold (COGS) for an external analyst.  Finally, Accounts Payable is driven by Purchases and so either Purchases if available or COGS is used in the numerator for this ratio.  Formally, we can define them as follows:

In addition, turnover ratios are often expressed in terms of number of days by dividing by the turnover ratio by 365:

First, we compare the Turnover Ratios:

The first row provides the Asset Turnover and the working Capital drivers of this turnover ratio are provided by Inventory, Accounts Receivables and Accounts Payable turnovers.  Remarkably, Wal-Mart has been attaining increasing Inventory Turnover each year and even through the US recession.  This is consistent with their business strategy in that during a recession, lower costs are more important to consumers, and is consistent with Wal-Mart boosting its Marketing expenditure to reinforce their strategy of “saving people money so they can live better.”  Wal-Mart is currently maintaining 2009 levels in their trailing twelve month numbers.  The inventory turnover is higher than Target’s.

Target’s inventory turnover did not fall off during the recession.  From the earlier example recall that Target experienced a recent declining Gross Margin trend.  As a result, this reinforces the conclusion that Target competed more aggressively on price during the recession and less on “shopper experience.”    As mentioned earlier Target has also increased attention towards groceries (with its PFresh initiatives) in an attempt to get better cross shopping results.  To the extent that these initiatives are successful, they should result in improved Inventory Turnover ratios.

From the Receivables Turnover, another clear difference emerges with respect to the business strategy for Wal-Mart versus Target.  Wal-Mart has higher receivable and payable turnovers than does Target.  In addition, Wal-Mart has unusually high Receivable Turnovers.  In order to gain more insight into these numbers we next consider these ratios expressed in units of time.

Here the differences between Wal-Mart and Target’s approach to working capital management become transparent.  Wal-Mart is converting receivables to cash much more quickly than Target.  Both companies take longer to pay their payables but again Target is slower.  From our earlier example, which revealed the aggressive low quick ratio that Wal-Mart has, it can be seen that their aggressive money management practice is built around an even more aggressive accounts receivable policy.  The Cash conversion Cycle Measure (Days to Sell Inventory + Days to Collect Receivables – Days to Pay Payables) provides a summary measure of the above:

It is clear that WMT completely dominates TGT in terms of cash conversion even though it is clear that Target’s management has focused on this over the recent few years.  The cash conversion cycle is related to how liquid the company is.  We examine this further next by considering liquidity ratios directly.