Friday, November 07, 2008

Following the Warren Buffett Way

Was sp impressed by Buffet's philosophy of investing, have started reading about Balance sheets and investing principles. Will post a few articles, summarising what I read everyday.

Balance Sheet
A balance sheet is a snapshot of the company’s financial position at a point in time.

It is organised in two colums . The left column lists what the company owns. The rigth column lists the sources of funds.

assets = liabilities +  equity

Asset types :
Assets can be current assets, which can be converted easily into cash. ( Invoices due, Inventory etc)

Non current assets cannot be quickly converted to cash. ( Goodwill, patents).

Current liabilities : to be paid in a year
Long term liabilities : due after an year

Equity :
Money invested in the business. When retained earnings are reinvested, the equity goes up.

In the asset side, the accounts are listed from most liquid to least liquid. Ditto forliabilities.

We can estimate the liquidity of a company with a variety of ratios :

Liquidity ratios

Current ratio : Current assets / Current liabilities.

Tells if a company has enough current assets to meet current liabilities.

But a high current ratio is not necessarily good - a company which has a sluggish turnover of inventory or whose customers take a long time to pay it, might have a great current ratio.

To dig deeper, we use the CCC.

CCC - cash conversion cycle states how efficiently cash is rolled over.The shorter the cycle, the more liquid the company is...

Or take the number of days it takes to convert inventory to sales , add to it the number of days for sales to get converted to cash. Subtract the number of days in which you pay your suppliers.

DIO : Days inventory outstanding

1. Get per day sales ( total sales / 365)
2. Calculate average inventory throughout year  (beginning inventory + ending inventory)/2 
3. Divide average inventory / per day sales tosee number of days it takes for the inventory to turn over.

DSO : Days sales outstanding

1. Get per day sales ( Tot sales /365)
2. Get average invoices due from customers ( Beginning accounts receivable + ending accounts receivable ) /2
3. Divide average invoices due / per days sales to see how many days the company takes to collect on sales

DOP : Days payment outstanding

1. Get per day sales ( Tot sales / 365)
2. Get average bills due  to suppliers( Beginning accounts payable + ending accounts payable ) /2
3. Divide average bills due / per days sales to see how many days the company takes to pay its suppliers.

Cash conversion cycle = Inventory turnover + Sales outstanding - Payment outstanding


or the company has to convert its inventory to sales, and convert sales to cash and then pay its suppiers.

Increase in DIO would mean a slack demand for company's products.

Shorter CCC means more liquidity and would mean the company is efficiently using resources.Use this in addition with current ratio to check a company's liquidity.

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