The eyes may or may not be a window into the soul, as Immanuel Kant suggested, but ratios are definitely a window into a company’s financial statements. They offer a quick shortcut to understanding what the financials are saying, no matter whether the company is a start-up, a small but growing company, a struggling midsize business, or a large, publicly held company. A Paine Webber analyst named Andrew Shore knew this and used his skill at analyzing ratios to tell the public about a fraudulently managed public company—Sunbeam, when it was run by the notorious CEO “Chainsaw Al” Dunlap. We’ve mentioned Sunbeam before in this book, but now we want to relate a few more of the sorry details.
Dunlap had arrived at Sunbeam in early 1997. By the time he got there, he already had a great reputation on Wall Street and a standard modus operandi. He would show up at a troubled company, fire the management team, bring in his own people, and immediately start slashing expenses by closing down or selling factories and laying off thousands of employees. Soon the company would be showing a profit because of all those cuts, even though it might not be well positioned for the longer term. Dunlap would then arrange for it to be sold, usually at a premium—which means that he was often hailed as a champion of shareholder value. Sunbeam’s stock jumped more than 50 percent on the news that he had been hired as CEO.
At Sunbeam, everything went according to plan until Dunlap began readying the company for sale in the fourth quarter of 1997. By then, he had cut the workforce in half, from twelve thousand to six thousand, and the company was reporting strong profits. Wall Street was so impressed that Sunbeam’s stock price had gone through the roof—which, as we noted earlier, turned out to be a major problem. When the investment bankers went out to sell the company, the price was so high that they had trouble identifying prospective buyers. Dunlap’s only hope was to boost sales and earnings to a level that could justify the kind of premium a buyer would have to offer for Sunbeam’s stock.
We now know that Dunlap and his CFO, Russ Kersh, used a whole bag of accounting tricks in that fourth quarter to make Sunbeam look far stronger and more profitable than it actually was. One of the tricks was a perversion of a technique called bill-and-hold.
Bill-and-hold is essentially a way of accommodating retailers who want to buy large quantities of products for sale in the future but put off paying for them until the products are actually being sold. Say that you have a small chain of toy stores, and you want to ensure that you have an adequate supply of Barbie dolls for the Christmas season. Sometime in the spring, you might go to Mattel and propose a deal whereby you’ll buy a certain number of Barbies, take delivery of them, and even allow Mattel to bill you for them—but you won’t pay for the dolls until the Christmas season rolls around and you start selling them. Meanwhile, you’ll keep them in a warehouse. It’s a good deal for you, because you can count on having the Barbies when you need them yet hold off paying for them until you have decent cash flow. It’s also a good deal for Mattel, which can make the sale and record it immediately, even though it has to wait a few more months to collect the cash.
Dunlap figured that a variation on bill-and-hold was one answer to his problem. The fourth quarter was not a particularly strong period for Sunbeam, which makes a lot of products geared toward summer—gas grills, for example. So Sunbeam went to major retailers such as Wal-Mart and Kmart and offered to guarantee that they’d have all the grills they wanted for the following summer provided they did their buying in the middle of winter. They’d be billed immediately, but they wouldn’t have to pay until spring, when they actually put the goods in the stores. The retailers were cool to the idea. They didn’t have anywhere to keep all that stuff, nor did they want to bear the cost of storing the inventory through the winter. “No problem,” said Sunbeam. “We’ll take care of that for you. We’ll lease space near your facilities and cover all the storage costs ourselves.”
Supposedly, the retailers agreed to those terms, although an audit conducted after Dunlap was fired failed to turn up a complete paper trail. In any case, Sunbeam went ahead and reported an additional $36 million in sales for the fourth quarter based on the bill-and-hold deals it had initiated. The scam worked well enough to fool most analysts, investors, and even Sunbeam’s board of directors, which in early 1998 rewarded Dunlap and other members of the executive team with lucrative new employment contracts. Although they had been on the job for less than a year, they received some $38 million in stock grants, based largely on the mistaken belief that the company had just had a stellar fourth quarter.
But Andrew Shore, an analyst who specialized in consumer products companies, had been following Sunbeam since Dunlap arrived and now was scrutinizing its financials. He noticed some oddities, like higher-thannormal sales in the fourth quarter. Then he calculated a ratio called days sales outstanding (DSO) and found that it was huge, far above what it ought to have been. In effect, it indicated that the company’s accounts receivable had gone through the roof. That was a bad sign, so he called a Sunbeam accountant to ask what was going on. The accountant told Shore about the bill-and-hold strategy. Shore realized that Sunbeam, in effect, had already recorded a hefty chunk of sales that would normally appear in the first and second quarters. After discovering this bill-and-hold game and other questionable practices, he promptly downgraded the stock.
The rest, as they say, is history. Dunlap tried to hang on, but the stock plummeted and investors grew wary of what Sunbeam’s financials were telling them. Eventually, he was forced out—and it all started because Andrew Shore knew enough to dig beneath the surface and find out what was really going on. Ratios such as DSO were a useful tool for Shore, as they can be for owners and others involved in entrepreneurial enterprises.
Ratios indicate the relationship of one number to another. People use them every day. A baseball player’s batting average of .333 shows the relationship between hits and official at bats—one hit for every three at bats. The odds of winning a lottery jackpot, say 1 in 6 million, show the relationship between winning tickets sold (1) and total tickets sold (6 million). Ratios don’t require any complex calculations. To figure a ratio, usually, you just divide one number by another and then express the result as a decimal or as a percentage.
Different people use different kinds of financial ratios in assessing a business. For example:
In this part we’ll show you how to calculate many such ratios. The ability to calculate them—to draw more information out of financial reports than the raw numbers alone tell you—is a mark of financial intelligence. We’ll show you how to use them to boost your company’s performance. As an entrepreneur, you will learn things from these ratios that you would never have known from just looking at the bottom line on your income statement, let alone the balance in the company’s checking account. You can then use that information to lead the company in the direction you want it to go.
The power of ratios lies in the fact that the numbers in the financial statements by themselves don’t reveal the whole story. Is net profit of $1 million a healthy bottom line for a company? Who knows? It depends on the size of the company, on what net profit was last year, on what net profit was expected to be this year, and on many other variables. If you ask whether a $1 million profit is good or bad, the only possible answer is the one given by the woman in the old joke. Asked how her husband was, she replied, “Compared to what?”
Ratios offer points of comparison and thus tell you more than the raw numbers alone. Profit, for example, can be compared with sales, or with total assets, or with the amount you and other shareholders have invested in the company. A different ratio expresses each relationship, and each gives you a way of gauging whether a $1 million profit is good news or bad news. As we’ll see, many of the different line items on the financials are incorporated into ratios. Those ratios help you understand whether the numbers you’re looking at are favorable or unfavorable.
What’s more, the ratios themselves can be compared. For instance:
There are four categories of ratios that owners, managers, and other stakeholders in a business typically use to analyze the company’s performance : profitability, leverage, liquidity, and efficiency. We will give you examples in each category. Note, however, that many of these formulas can be tinkered with by the financial folks to address specific approaches or concerns. Tinkering of this sort doesn’t mean that people are cooking the books, only that they are using their expertise to obtain the most useful information for particular situations (yes, there is art even in formulas). What we will provide are the foundational formulas, the ones you need to learn first. Each provides a different view—like looking into a house through windows on all four sides.