FIN 460 Week 2 Ratio and Working Capital Analysis Example

Twelve Ratios and One Problem: Liquidity, Turnover, Margins, a DuPont Breakdown and Lease-Adjusted Debt Show Where Trailhead Outfitters Trails Its Peers

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University of Phoenix

FIN/460: Fundamental Analysis

Week 2 Assignment

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[Date]

Trailhead Outfitters, its peers and all figures are composites written for a model paper; ratio methods and research findings come from the sources listed.

Week 1 left the analyst covering Trailhead Outfitters, the composite outdoor gear retailer, with five questions, the first being whether its inventory turns more slowly than peers'. Ratios answer that and more. Peer figures come from the median of four comparable specialty retailers' latest annual reports, and prior-year figures from Trailhead's previous filing. A ratio by itself is a number; a ratio set beside last year's figure and a competitor's becomes evidence. This paper builds that evidence.

Liquidity

The current ratio, current assets of $730 million divided by current liabilities of $470 million, is 1.55, close to the peer median of 1.6. The quick ratio, which excludes inventory, is only 0.40 against a peer median of 0.5. Retailers typically show low quick ratios because inventory is their main current asset, so the quick ratio mostly confirms that Trailhead depends on selling its goods to meet short-term obligations. Liquidity is adequate but not generous.

Activity

Dividing the year's cost of goods sold by the $540 million of inventory gives turnover of 2.6 times, or about 139 days of inventory. The peer median is 3.4 times, about 107 days, and Trailhead's own figure a year earlier was about 124 days. Receivables are negligible at about five days, since most sales are paid by card. Payables run about 67 days, close to peers. Total asset turnover is 1.26, below the peer median of 1.4.

Profitability

The gross margin is 41.0 percent against a peer median of 41.5 percent, and down from 41.8 percent the prior year. The operating margin is 7.0 percent against a peer median of 8.5 percent and a prior-year 8.1 percent. The net margin is 4.7 percent. Return on assets is 5.9 percent and return on equity 19.4 percent, the latter above the peer median of 17 percent.

The DuPont Breakdown

The DuPont identity splits return on equity into three multiplied parts: how much profit each sales dollar keeps, the revenue generated per dollar of assets and the assets carried per dollar of shareholders' money. For Trailhead, 4.69 percent times 1.26 times 3.28 equals 19.4 percent. The peer median breaks down roughly as 5.6 percent times 1.40 times 2.17, about 17 percent. Trailhead's higher return on equity therefore comes entirely from a higher equity multiplier: it earns less on each dollar of sales and uses its assets less efficiently, but finances more of its assets with liabilities. Nissim and Penman (2001) recommend separating operating returns from financing effects precisely because financial structure can make a weaker operating business look stronger.

Solvency and Leases

Conventional debt of $250 million against equity of $580 million gives a debt-to-equity ratio of 0.43. Adding $650 million of lease liabilities raises it to 1.55, against a peer median near 1.2 on the same basis. Operating income covers interest about 9.3 times, comfortable, but a fuller measure adding about $110 million of annual lease payments to both sides gives fixed charge coverage of about 2.2 times, much tighter. Leases are where Trailhead's obligations really sit.

The Cash Conversion Cycle

Days of inventory of 139 plus days of receivables of about 5 minus days of payables of 67 gives a cash conversion cycle of about 77 days, compared with about 45 days for peers. Every day of the cycle ties up roughly $3.9 million of cost of goods. The 32-day gap with peers represents about $125 million of extra cash tied up in operations.

Market Ratios

At $34 a share and earnings per share of $2.25, the price-to-earnings ratio is about 15, close to the peer median of 15.5. The market is valuing Trailhead roughly in line with peers despite weaker operating ratios, which suggests investors expect improvement.

What the Ratios Say Together

One problem explains most of the gap: slow inventory. Excess inventory lowers asset turnover, raises the cash conversion cycle, ties up cash and, when goods must be cleared, cuts gross margin through markdowns, which helps explain the margin decline. Fairfield and Yohn (2001) found that changes in asset turnover help predict future changes in profitability, while profit margin alone does not, which suggests that Trailhead's turnover trend deserves close watching.

What Fixing It Would Be Worth

If Trailhead reduced days of inventory to 115 over two years, it would release about $93 million of cash and, by reducing markdowns, could recover perhaps half a point of gross margin, worth about $12 million of operating income a year. Management's discussion cites a new allocation system intended to do exactly that, which Week 4 will test.

Checking the Peer Set

Ratios compared with the wrong peers mislead. The four peers chosen are specialty retailers selling branded outdoor and athletic goods through stores and online, with revenue between $1.5 billion and $5 billion. Big-box sporting goods chains were excluded because they sell broader categories with faster-turning goods, and online-only sellers were excluded because they carry no store leases. Removing the largest peer from the median changes days of inventory by only three days, so the conclusion does not depend on one company. A careful analyst also checks that peers use the same inventory method; all four use average cost, as Trailhead does (Penman, 2013).

Limits of Ratio Analysis

Ratios depend on accounting choices and on the date of the balance sheet; a retailer reporting at its seasonal low in inventory looks better than one reporting at a high. Trailhead and two of its peers end their fiscal years in early February, after holiday clearance, making comparisons fair among them. The other two peers end in late January, close enough that seasonal timing does not distort the comparison.

Conclusion

Trailhead's liquidity is adequate and its return on equity looks strong, but the DuPont breakdown shows that strength comes from liabilities, mostly leases, while margins and asset turnover trail peers. Slow inventory is the single problem behind most of the weakness, and fixing it would release cash and support margins.

References

Fairfield, P. M., & Yohn, T. L. (2001). Using asset turnover and profit margin to forecast changes in profitability. Review of Accounting Studies, 6(4), 371-385. https://doi.org/10.1023/A:1012430513430

Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6(1), 109-154. https://doi.org/10.1023/A:1011338221623

Penman, S. H. (2013). Financial statement analysis and security valuation (5th ed.). McGraw-Hill Education.