Analysis Paper Step #3 Procedure: Efficiency paragraph addition to the paper
This step helps us evaluate one aspect of company operations called efficiency. We use a very narrow definition of efficiency for this case. Efficiency in this case only considers how well a company utilizes their assets to generate sales revenue. We assess this by comparing the sales revenue earned by the company to the total amount of assets the company shows on their balance sheet. This ratio is sometimes called the efficiency ratio, but is more commonly known as the asset turnover ratio:
We are measuring Efficiency with the asset turnover ratio.
Asset Turnover = Total Revenue ÷ Average Total Assets.
Efficiency can be viewed as a longer term performance measure than profitability since it deals with all assets, including long term assets which can be in service for years. To perform well in this metric, a company has to source assets that help them create and deliver products and services that consumers want. They must be very careful to limit acquisitions of assets that don’t help deliver value to customers. If assets don’t drive sales, performance in this efficiency metric drops.
The asset turnover ratio helps us evaluate how well a company sources assets to support their ability to produce sales revenue. Since asset turnover compares total assets to sales revenue, either high sales or low assets drive high results. Sales revenue increases also show up as improvements in the profitability ratio so we evaluate sales performance there. We will use asset turnover to assess how well management controls the amount invested in their assets to support their sales level. Therefore, we will focus our efficiency analysis more on the asset side of the formula to emphasize management’s role in controlling asset purchases to match the needs of the achieved sales volume of the company. Management needs to carefully align asset investment with sales volume to avoid building a business model so expensive that their sales can’t support the asset funding required.
Assets require funding which is sourced through borrowing and owners’ equity. Sourcing assets costs money; and whoever provided that money to the company will expect a return. If a company can create lots of revenue with few assets, then they don’t have to pay so much of their earnings to lenders or to additional shareholders to fund the assets. Run lean on assets, and earnings won’t have to be shared with as many lenders and shareholders.
Keep in mind, this case is NOT just about buying and reselling assets like inventory. It is about judging how well management sources and utilizes ALL of their assets to help make sales happen. A car manufacturer isn’t selling their manufacturing plant, but a busy plant means the plant is the right size to support the amount of cars they produce and sell - efficiently. Busy, useful assets make sales happen. Idle, useless assets don’t generate revenue. That’s what this metric best assesses.
First we will find the numbers, then analyze those numbers to find and explain asset turnover performance. If your company performs poorly in this metric, then we have an extra step to find any unusually large asset line items that might be the cause of the low performance.
Finding asset turnover numbers on the income statement and balance sheet:
To Yahoo Finance! https://finance.yahoo.com/
From the company summary page, click the financials link.
Pick the annual income statement, then grab the Total Revenue figure (same as before).
Navigate to the annual (year end) balance sheet.
Be very careful to pick the “Total Assets” number. Do NOT drill down to pick any subtotal.
Calculating the asset turnover ratio:
Note: All those numbers shown in Yahoo Finance are in thousands of US Dollars. The numbers are not converted here because they are too big. Remember to multiply times 1,000 to see their real size.
To help us judge how well HOG manages their assets to efficiently support sales revenue, we can calculate the asset turnover ratio like this:
Asset turnover = total revenue ÷ average total assets.
We need to calculate the average total assets first. The ending balance of the prior year is also the beginning balance of the current year. Since we want to see the amount of assets on hand over the course of the most current year, we need to consider both where they started and where they end up. On average, this is how much they had in assets during the most current year.
(last year ending balance + current year ending balance) ÷ 2 = average total assets
($10,665,664+$10,528,159) ÷ 2 = average total assets
$21,193,823 ÷ 2 = average total assets
$10,596,912 = average total assets (note: times 1,000 to see the real number)
Now we can plug that calculated average total assets amount into the asset turnover calculation. Since neither number has been converted to their actual size, the resulting percentage is correct.
Asset turnover = total revenue ÷ average total assets.
Asset turnover = 5,361,789 ÷ 10,596,912 = 0.50598
Converting that decimal to a percentage:
0.50598 * 100 = 50.598%, round to 51%
Note: Please do not copy this math process and show it in your paper. The reporting form only requires the calculated number, just the end result.
Interpreting your asset turnover calculation results:
100% is our minimum benchmark for most companies. Higher results indicates that they have an appropriate amount of assets for their current level of sales – their assets are being used to make sales happen. The fewer assets that are required to make sales happen, the easier it is for the sales to generate enough profits to support those assets. Higher is generally better with some extremely efficient companies even in extreme cases doubling our 100% benchmark. Less than 100% means that the company is not using their assets efficiently to generate sales. We don’t know why yet, and we need to avoid speculative guesses in your interpretation at this stage until we identify the problem later. The key problem that a low asset turnover tells us is that the company has more assets than would normally be required at their current sales revenue level. We cannot tell them how to fix this, we can only tell them that they have more assets than normal at this level so they are inefficiently managing their assets.
Different industries result in very different outcomes of this measure. The 100% minimum performance threshold works for almost all industries except for financial services which can be much lower. Consider how a bank works to understand why. Bank Co. takes in deposits of $1 million. Then Bank Co. Loans that money out at 5% interest. That interest earned is the revenue for Bank Co., so 5% of $1 million = $50,000 of revenue. This results in a horribly low efficiency performance of $50,000 ÷ $1,000,000 = 5%. That is 95% less than our benchmark, a seemingly awful performance! This can work for a bank though because they might only pay about 1% interest to depositors. They are still making a 5%-1%=4% spread of profits. Any company that offers significant long-term financing to its customers can have their asset turnover drawn down by the financing segment of their company. If you omit the financial assets then recalculate their asset turnover ratio, you can estimate their core business efficiency. If this change brings their ratio up to 100%, then they are managing their other assets well. Do this if your efficiency is low and your company has significant receivables owed to them by their customers: GM, Ford, and even HOG.
Strategic variations: Different approaches within an industry can lead to different outcomes. Resale car businesses vary widely in their efficiency results. Sometimes this is because of more effective management, but sometimes it is just because of different strategies. A car seller that owns the land and carries a large inventory of cars will tend to have a low asset turnover measure. A car seller who rents the lot will tend to have a bit higher asset turnover performance. A car broker that maintains strong sales without having a car lot and without holding any inventory can achieve an incredibly high asset turnover.
If your company’s asset turnover is 100% or greater, then they are managing their assets efficiently and your job amounts to commending them and explaining how their strong efficiency relates to the lower funding required to source their lean assets and how lower asset levels relative to sales volume makes this easier. In such a situation you would not need to evaluate the asset line items any further to find a problem since there is no problem.
If your company’s asset turnover is less than 100%, then you need to find the problem asset line item on the balance sheet and explain how/why it is causing the efficiency to be low and why that matters. The next section helps you find and evaluate such problems only for companies with low efficiency.
Finding and explaining the causes of LOW efficiency (Only if your efficiency is <100%)
This does not apply to you if your company’s efficiency is 100% or higher.
HOG’s efficiency is only about 51%, so we need to identify and explain the problem line item.
Since our emphasis in using the asset turnover ratio is on management of the assets, we need to find the largest asset item(s) to explain why efficiency is low. If your asset turnover result is not low, do not do this.
After you find the problem asset line items, scroll down to read about how interpret the problem caused by your specific line item. Navigate back to the balance sheet, then locate just the asset section for the current year end report.
First, locate your Total Assets line item. This will be our base to compare all other items. Click the “>” symbol on the Total Assets line to reveal more asset line items. Keep clicking the resulting line items with the “>” symbol to drill down to see all available asset details. Close detail for items that are too small to worry about to minimize clutter. Remember, we are looking for the big line items here that are keeping our company’s asset turnover below 100%.
After expanding the larger items, and collapsing the smaller items, the balance sheet below shows the level of detail needed to describe how the problem assets were found, and to lead us to interpreting the problem line items.
Total assets is a bit over $10 billion. Current assets make up about 40% of that, and Non- Current assets (aka long term assets) amount to about 60% of that $10 billion. These are both big enough to hide big line items, so we should expand them both for more detail.
Accounts receivable is by far the largest line item within current assets, though if we mathematically eliminate it from the asset turnover calculation it would only get us up to around 75%, so this line item is not quite big enough to explain our low efficiency.
Expanding Total non-current assets reveals the line item “Non Current Accounts Receivable” of a little over $5 billion. If that were removed from the calculation our asset turnover would be right at 100%, so this line item is big enough to be our efficiency problem.
Often, recalculating asset turnover without the largest asset gets asset turnover back up to 100%. If not, then keep removing the next biggest asset item from the asset turnover calculation, and recalculate until asset turnover gets up around 100%. Then you have identified the line item(s) to identify the efficiency problem. Once done with that, scroll down to see how to interpret that problem line item.
The following sections provide insight toward explaining the relevance of the line item causing your company’s inefficiency. If one of the following items are causing your low efficiency, explain the problem using these concepts.
Interpreting common asset problem areas:
Cash and Cash Equivalents / Short Term Investments / Long Term Investments
This is essentially a big pile of cash sitting around doing little or nothing to earn revenues. Since it isn’t doing anything, it isn’t generating return for shareholders. Short term investments earn a little return for these mostly unproductive assets. Long term investments often means the company expect to be parking this idle cash for a long time. All assets are funded by debt and/ or equity, and those sources require returns. If your company has low efficiency caused by high amounts in these line items, they may have a successful core business but they could increase shareholder value by paying this idle cash to them. In other words, this is a problem with great potential and an easy fix.
Selling to customers on credit is very common. From what we learned with Harley Davidson, Yahoo doesn’t appear to put all customer receivables here. Don’t expect to find any problems here. Only really poor collections performances would have any effect on this metric, and the problem would have to be way out of line to be relevant here. See the A/R turns metric in the textbook for more details on analyzing collections, though it is outside the scope of this case.
If this number is causing low efficiency, then the company must have way too much merchandise intended for sale. It is highly unlikely this line item could be so out of line as to cause a meaningful drag on efficiency. If this is the case, please locate “inventory turnover” in the textbook index and use that tool to evaluate their inventory management. Inventory turns normally need to be three or more if a business is going to be successful.
Other Current Assets
If this is a problem the line item detail can be found in the SEC 10-k report. Get help from your instructor if needed.
Property Plant and Equipment
These are the land, buildings, equipment that companies use to run the company. If efficiency is low and this number is big, then the company is not investing efficiently in assets that create what customers want. The business model may be obsoletely or just have way too much expensive productive capacity for their level of output. Multiple company acquisitions could cause this problem through excessive duplicate capacity. If PP&E is too big, you have a major mismanagement issue. PP&E Net is what matters here, that’s the number with depreciation deducted.
Goodwill / intangible assets
Goodwill is an asset that gets on the balance sheet only from buying other companies and paying more than the net asset value of the acquired companies. If efficiency is low and goodwill is high, it means that the company is paying too much to buy other companies that are not generating enough sales. This is a much more common problem than it should be. It
indicates that management may be trying to hide poor organic growth by buying growth through acquiring other companies. Intangible assets like patents or copyrights are similar to goodwill in that they only show up on the balance sheet if they are purchased from elsewhere. If these are high and efficiency is low then the company is buying intangible assets that aren’t creating enough sales.
Non Current Accounts Receivable
When a seller finances customer purchases in house, the amount owed to the seller by the customer appears here. This is in effect a separate finance company within the company. As per the earlier description of why banks have such low efficiency, this can dramatically lower a company’s calculated efficiency just because the interest charges on financed amounts are small which drives down efficiency rates. Generally this is not because of poor management. If eliminating this line item from the asset turnover calculation brings the result up to around 100%, then the core company is efficient enough, and the addition of the financing arm of the company is making it look worse than it is.
Other assets / Deferred Long Term Asset Charges
It is very rare that anything here has a material effect on efficiency. If it does, look to the 10k report at www.sec.gov. That report will have all the detail needed to explain. Ask your instructor for assistance if needed.
Analysis Paper Step #3 Reporting Form: Efficiency paragraph
Student Name: Your company name: Company ticker symbol:
Include your revised introduction paragraph and profitability paragraph from your earlier work at the beginning of your write up in normal essay sequence. Reflect any provided feedback in this newest revision. Follow those earlier paragraphs with your new efficiency paragraph. Include the following information in this new efficiency paragraph in the sequence presented here:
The purpose of this efficiency paragraph to the reader
Your calculated efficiency (asset turnover) number (Not the math, just the number)
A comparison to the provided minimum asset turnover benchmark
Your interpretation of what that efficiency performance conveys toward fulfilling the purpose of the paragraph
Any identified unusually large line item(s) that adversely impacts efficiency (ONLY needed IF your company has efficiency BELOW 100%.)
The relevance of the large asset line item(s) causing your efficiency to drop below 100% (ONLY needed IF your company has efficiency BELOW 100%.)
Your overall judgement of their efficiency performance and how that reflects on management performance (This must directly fulfill the purpose statement that began this paragraph.)
Remember, the semester long assignment goal is a term paper, not a list of answers in Q & A format. Online classes, post your entire to-date essay progress, in-person classes always bring your entire to- date essay to class for discussions. Each step requires all prior paragraphs to be included in their normal expected essay sequence.