QIS Capital Conference October 2005

Exploring Fundamental Analysis

Liquidity Ratiosby Grant Robertson, B.B.A.

Key Principles of Fundamental Analysis

- no strict benchmarks – fundamental analysis is relative measure and acceptable benchmarks may vary from industry to industry, stage of growth, etc.

- while some fundamental analysis measures are indeed objective, most still require subjective evaluation (it is merely one more tool that investors have at their disposal – it will not make sound decisions for us).

- fundamental analysis is not only concerned with current state, but changes in key measures over time

Working Capital

Working Capital = Current Assets - Current Liabilities

The current assets and current liabilities figures can be found on the company's balance sheet.

Current assets include: Cash Short-term deposits Liquid marketable securities Accounts receivable Inventory Prepaid expenses Other assets which are expected to be or could easily be

liquidated into cash within a period of one year or less.

Working Capital Cont.

Current liabilities include: Short-term bank debt (demand loan or line of credit) Accounts payable Deposits received from customers for future delivery of

products or services Taxes and payroll remittances payable to the

government The portion of the company's long-term loans (principal)

that will be repaid during the next 12 months.

Working capital essentially measures the company's ability to discharge all of its short-term obligations (those coming due within the next 12 months) without relying on operating cash flow and external financing.

Working Capital Cont.

Commonly measured by 2 key ratios:

Current Ratio = Current Assets / Current Liabilities

Ratio of 2.0 of higher preferred in most industries, although 1.0 for a profitable, growing small-cap is often sufficient to give comfort as to current financial liquidity where receivables and inventory turnover is stable or improving.

Quick Ratio (Acid Test Ratio) =(Current Assets – Inventory) / Current Liabilities

Ratio of at least 1.0 preferred in most industries.

Working Capital Cont.Value to Investors / Analysts: Measure of funds available to grow business without using operating

cash flow or external financing Can help identify companies in need of additional financing so

investor / analyst can take into account potential dilution from future share issuances, interest costs on financing, etc.

Can be early indicator of financial insolvency, receivership, or bankruptcy, or alternatively an indicator of excess cash reserves which may indicate possibility of special dividend, hidden cash value, takeover candidate etc.

Limitations: Is only a snapshot of financial position as of a specific date, therefore,

investor must consider changes in financing and operational activities since date of the balance sheet (private placements / offerings)

Does not take into account debt service costs (interest on debt) and contingent liabilities, other debt covenants, etc.

GAAP classification of certain demand loans (Oil & Gas sector)

Receivables Turnover

In simple terms, this ratio measures how quickly the company can expect to get paid when it provides credit to its customers.

Annual or Annualized Sales / Accounts Receivable

Can also be expressed as # days (easier to interpret)

365 days / Receivables Turnover Ratio

Benchmarks:Less than 30 days –very good, 30-45 days good,

45-65 days fair, 65-90 poor, over 90 days very poor

Receivables Turnover

Uses: reflects effectiveness of credit granting and collection

policies can be used to identify impending bad debts and write-

offs can reveal industry slowdown that may affect future

business as customers extend credit as they begin to struggle with the industry slowdown

Limitations: must factor into account seasonality issues with respect

to company’s revenue stream can give misleading analysis results on smaller

companies with “lumpy” revenue streams, especially those with unusually large contract revenues

Receivables Turnover

Best analysis value of this ratio comes from examining CHANGES in this ratio over time and compared to industry comparables

Is the turnover of receivables slowing or becoming more rapid? A progressive slowing on the receivables turnover rate on a quarter-over-quarter basis is generally a cause for alarm. At the very least, it should raise questions for further due diligence.

Can also be compared to payables turnover ratio (Cost of Goods Sold/Accounts Payable). An increase in accounts payable turnover and a slowdown in receivables turnover can quickly eat away at working capital and cash reserves.

Inventory Turnover

In simple terms, this ratio measures how long, on average, inventory must “sit on the shelves” before it is sold to a customer.

Annual or Annualized Cost of Goods Sold /

Inventory

Can also be expressed as # days (easier to interpret)

365 days / Inventory Turnover Ratio

Inventory Turnover

Uses: can be used to identify obsolete inventory accumulation,

reduction in product demand, new competition, over-production issues etc. which can hint as to future demand for product, possibility of write-offs, etc.

Limitations: must factor into account seasonality issues with respect

to company’s business and timing of inventory purchases (ex. build-up of retail inventories prior to Christmas season, or increase in inventory in anticipation of shipments for a major contract, etc.).

inventory turnover depends greatly on the nature of the business being evaluated (fresh produce vs. jet aircraft)

Best value comes from analyzing changes over time.

Inventory Turnover

General risks of holding too much inventory:

unnecessary use of capital that could be employed elsewhere

increased warehousing cost, including insurance changes in prices (value), styles, or consumer

acceptance

General risks of holding too little inventory:

can't meet sales demand; miss out on important sales opportunities

unable to deliver product on time to meet customer requirements could result in customer switching to a more reliable supplier

Summary

it only takes a few minutes to do these basic calculations and they can reveal a great deal about a company’s financial position

focus on examining trends in changes in these ratios on a quarter by quarter basis

it you find a concerning trend in a ratio, call management and ASK QUESTIONS – and more importantly, scrutinize the answers you get.

there are a series of three articles discussing working capital, receivables turnover and inventory turnover on the QIS Capital website in the educational articles section

Example: (PIH) Working Capital: F05: $11,199,272 – 4,524,629 = $6,674,643 F04: $11,070,042 – 3,288,500 = $7,781,542

Current Ratio: F05: $11,199,272 / 4,524,629 = 2.5 F04: $11,070,042 / 3,288,500 = 3.4

Quick (Acid Test) Ratio: F05: ($11,199,272 – 4,437,900) / 4,524,629 = 1.5 F04: ($11,070,042 – 4,409,961) / 3,288,500 = 2.0

Example: (PIH) Receivables Turnover:

F05: $30,064,600 / 5,104,276 = 5.9 or 62 days

F04: $26,440,172 / 4,182,210 = 6.3 or 57 days

Inventory Turnover:

F05: $23,761,683 / 4,437,900 = 5.4 or 68 days

F04: $20,767,735 / 4,409,961 = 4.7 or 77 days