Master Class 5: Asset Turnover, Cash Cycle Ratio and Share Split
Created on 28 Aug 2020
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Updated on 21 Sep 2022
Have you seen the applications of your peers? Sometimes the achievements, degrees, and skills exceed their age. We try and hone our skills in every way possible. Similarly, to add more feathers to your cap of stock market analysis techniques, let us take you through another two important ratios:
The two undervalued metrics of fundamental analysis are,
- Asset turnover ratio.
- Cash cycle.
(Source: HUL, from Ticker)
Asset turnover ratio
Imagine you are a cab driver. While there are numerous factors that influence your revenue, a great contribution will depend upon how effectively you optimize between the rides and use your car in the best possible way. Like in the example, the asset turnover ratio measures how effectively a company uses its assets to generate revenue. It compares the total of assets with the net sales or revenue of the company. The asset turnover ratio is calculated mostly at the end of the year or the end of the accounting period. Duo point analysis also relies upon the Asset turnover ratio.
Asset turnover ratio = Net sales (or) net revenue / assets
How do you interpret it?
Idle assets are futile. Hence, using the Asset turnover ratio, investors can calculate the state of a particular group of assets belonging to the firm, such as current assets or fixed assets. It is advisable to choose a company with a higher ratio. However, the benchmark might vary from industry to industry. Hence, drawing a comparison between its competitors is highly advisable. For example, a company in the service sector might hold a good asset turnover ratio when compared to its counterparts, yet, be less than the ones in the industrial sector. Sometimes companies may sell assets at the end of the period to falsely pump up the figures. Be cautious in such scenarios.
Cash cycle ratio
A cash-cycle ratio is a useful tool in calculating a company's efficacy in converting its inventory or investments into cash. In short, it helps the investor understand how long it takes for the cash employed to finish its entire cycle, from inventory to accounts payable to cash again. The cash cycle ratio is used for the internal management of the company as well. Especially in adjusting credit purchase and cash collection policies, one can seek the help of a cash cycle ratio. This method is also termed as a cash conversion cycle or Net operating cycle.
Cash cycle ratio = DIO + DSO – DPO
DIO – no. of days of inventory outstanding.
DSO – no. of days sales outstanding.
DPO – no. of days, the payables are outstanding.
Have you read our previous Master Class: Understanding Return on Equity and Net Profit Margin ?
Significance of cash cycle ratio
Say you own a wholesale stationery shop. Your goods are delivered to the customers, but the cash hasn't been realized. In such a case, there is a high chance of default, resulting in bad debts. Increasing bad debts might render unforeseen challenges making it difficult to run business. Hence, if the company you purchased has a good cash cycle, then it's a great plus.
Unlike the asset turnover ratio, having a company with a low or negative cash cycle ratio is better. As an investor, it allows you to interpret the company's management and the effectiveness of its operations. It is always helpful to compare a firm's current CCC with its previous or historical ones and with its competitors. It is a good sign if the historical data projects a decreasing or steady ratio. A higher or increasing ratio might be as a result of increasing payables, constraints in sales, inventory mismanagement, etc.
Do corporate actions matter?
Absolutely, corporate actions also impact the price movements of a particular stock. So today, let's decode two important corporate actions that might affect your stocks. Usually, these two are mixed up and wrongly inferred driving home numerous issues. So let's get it cleared once and for all.
When a company issues free additional shares to its existing shareholders, it is called a bonus issue. However, the shareholder becomes eligible to receive the bonus issue's benefits only if he holds the company's share as of the cut-off date or record date. It is also called a scrip issue or capitalization issue. This happens to be an alternate option for dividends.
Here, the overall capital or net assets remains the same. But the share capital of the company increases. The accumulated earnings of the firm are mostly used to issue bonus shares. Hence, there is no actual cash flow.
Example: Say Mr.X holds 100 shares of company B. The company announced a bonus issue in the ratio of 2:1. This means for every 1 share held; the investor will receive 2 shares. So Mr.X will receive 200 additional shares, increasing the number of shares held to 300. In this case, the price of the share faces a fall for a short period. But in the long run, the stocks will gain as it attributes to the company's positive health. But in some cases, the price might increase tremendously in the short term owing to the optimism prevailing in the market.
Benefits to the stakeholders
- A bonus issue is sorted by the company when the company is short of cash but still has to declare a dividend.
- The company is perceived as a big enterprise, which in turn makes it an attractive investment.
- Helpful in increasing the equity base.
- The company might issue shares when it is restricting its reserves.
- These shares are not taxable at the time of the issue. Thus, a good option for a long term investor who is looking forward to increasing his investment. Having said that, the shares are taxed at the time of selling them just like any other share.
- It is a sign that the company is keen upon future growth.
- An increase in the number of shares outstanding might reduce the share price in the market. Hence, retail investors who earlier found it difficult to make investments can do it now.
Unlike the bonus issue, share split involves splitting the already outstanding shares of a particular company. The market capital of the company remains the same. But the number of shares is increased, and the face value is reduced.
Example: Mr. X holds 10 shares of company B priced at Rs.100. The company announced a share split. So X has 20 shares now. However, the underlying value of his investment remains unchanged i.e., Rs.100.
Let us take a real-life example. In June, the Board of Eicher Motors declared a share split in the life ratio of 1:10. That is, every share which is having a face value of 10 will be divided into 10 shares with a face value of 1. The decision came into effect with the hope of increasing liquidity in the market. This resulted in a 7% increase in the value of shares.
The following table explains the changes that might occur in the books after and before the split,
Other important pointers include the following
- The price of the stocks may decrease, allowing the retail investors to make investments.
- Sometimes the shares may be priced extremely high. As a result, they may affect the liquidity of the market. A fall in the price due to split increases the liquidity and increases the trade activities enabling stock to realize its true value.
- A share split simply splits the company's authorized capital while the bonus issue changes the issued share capital.
The year 2019 saw a record-breaking Demat account opening. This suggested that more and more people realize the relevance of the stock market and the importance of investing. It's time you grab your opportunities as well. Still, perplexed? Then take a few minutes and refer Youtube Video, Because once it escapes, it's gone forever.
To understand more see the next blog: To identifying the Bad Companies, Cash Flow Statement and Rights Issue
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