Introduction

In this first part of our new series looking at the financial performance of small cap public OFS companies, we dive into operating cash flow and some related metrics that OFS companies should monitor continuously. An OFS company’s success can be directly impacted by its cash flow management effectiveness throughout the commodity cycle. Without sufficient cash flow, one may encounter various challenges in continuing business operations and may even be on the brink of bankruptcy if cash flow issues persist over a prolonged period of time.

The objective of this series is to provide you with a better understanding of how your OFS business is performing compared against a selection of publicly traded small cap OFS companies based on various cash related financial metrics. We believe that through this analysis, you will be able to improve your performance tracking and identify both areas of improvement and the resulting tangible implications.

Analysis Framework

Our analysis covers the Canadian publicly traded OFS companies with a market cap below $160 million as at June 14th, 2019. The list of constituents is as follows:

Based on the average financial performance of the selected OFS companies, we prepared the tiering system below based on three metrics: cash margin, cash conversion cycle (CCC) and asset efficiency. The cash margin and the asset efficiency metrics are calculated with operating cash flows, defined as follows:

Operating Cash Flow (OCF):

A measure of the amount of cash generated by a company's normal business operations.

OCF = Net income plus non-cash expenses plus changes in working capital.

A.     Cash Margin (OCF/Sales)

• Calculates the percentage of each sale that turns into operating cash flows.

• The higher the ratio, the greater the amount of cash generated from a sale.

• Top Tier 2018 Performance: 25.3%

• Top Tier Performance (2012-14): 33.3%

• Your Performance:

Note: working capital has a significant impact on operating cash flow. The large increase in 2015’s cash margin is due to two key factors: a significant drop in average sales (35% decline) and a significant shift in working capital (significant drop in accounts received from 2014 as well as a large increase in payables outstanding). The net influx of working capital divided by a smaller sales number results in a spike in the cash margin. 

B.     Cash Conversion Cycle (CCC)

• Provides key insights on areas for improvement and areas of concern.

• Consists of three components:

  • Days sales outstanding (DSO)

  • Days payables outstanding (DPO)

  • Days inventory outstanding (DIO)

• CCC = DSO – DPO + DIO

•  Top Tier 2018 Performance: 25.3 days

• Top Tier Performance (2012-14): 27.7 days

• Your Performance:

• The CCC is made up of three key pieces of working capital:

  • Companies with excessive DSO could have a collection problem (i.e. not effectively chasing customers for payment), or a delivery problem (unsatisfied customers result in invoicing disputes) or both. 

  • High DIO tends to indicate either overbuilding of inventory or declining demand. 

  • Extremely high DPO often indicates cash flow problems resulting in payables being stretched, or in the case of an extremely low DPO a business may be on a cash-on-delivery basis with suppliers.  Understanding what factors are driving your numbers is important for any analysis.   

i - Days Sales Outstanding (DSO)

• Reflects how much time sales sit in receivables.

• DSO = (Average Accounts Receivable / Sales) * Number of days in period

• The higher the number, the worse your collection time period. 

• Over the historical period analyzed, we see the top tier’s DSO being maintained within a relatively narrow range of 60 to 65 days.

ii - Days Payable Outstanding (DPO)

• Reflects the length of time to pay vendors.

• DPO = (Average Accounts Payable / COGS) * Number of days in period

• Many of our clients fall in the 30-35-day range, which is about the industry average. In general, we are comfortable with our clients having a DPO of 35-45 days (i.e. second tier). 

• A high DPO can indicate that a company is having cash flow issues. Similarly, an OFS company with a below average DPO may indicate that it is operating almost on a COD payment basis with its suppliers.

iii - Days Inventory Outstanding (DIO)

• Reflects the length of time inventory is stocked before shipped to customer.

• DIO = (Average Inventory / COGS) * Number of days in period

• We do not often think of this coverage universe as having significant inventory. If your business has inventory, it is important to manage it accordingly as we have seen many businesses hold an excess amount of capital in their inventory accounts.

• Depending on lead times and the nature of your business, we should discuss any inventory metrics with you in greater detail to help understanding where there may be efficiencies and opportunities to take advantage of.

C.     Asset Efficiency (OCF / Total Assets)

• Top Tier 2018 Performance: 20.3%

• Top Tier Performance (2012-14): 25.3%

• Your Performance:

•  Asset efficiency measures how much cash you generate off your assets. This differs slightly from the asset turnover ratio which compares net income or sales to the asset base.

• Asset efficiency assists in understanding business asset usage and like the cash cycle, can help identify areas for improvement or concern.

• A high asset efficiency may indicate strong asset usage, but it can also point to an aging asset base with a declining book value. While this may not have impacted OCF yet, it runs a risk of doing so over the long-term A low asset efficiency may reflect newer assets with higher values or a business that is under performing.  A negative asset efficiency is not a good sign. 

We see a significant drop off within our small cap sector after the top tier.Key factors to consider in the details of this ratio include age of fleet and the capital intensity of your fixed assets. There is a balance between investing in new assets and benefiting from cash flow generated from older assets. That balance is important in maximizing this ratio and can help business owners in determining when to pursue new asset purchases or investment.

Why Understanding Your Numbers vs. Your Competitors is Important

• First, understanding what the numbers are telling you goes beyond simply comparing one metric to another. 

  • Owners and managers should understand how decisions impact the numbers, and what factors can alter performance or mask poor performance.

  • A ratio is meaningless without understanding the underlying causes/effects.

• Cash is king – and generating more cash flow from your assets and operations than your competitors can provide you with a key operational advantage.

  • Operating cash flow helps fund debt, capital acquisitions, dividends and growth.  Managing operating cash flow involves the whole income statement and key working capital accounts. 

  • The cash cycle can help identify some key areas that are delaying your ability to generate cash, or in the case of inventory, where you have over-invested cash.

• Knowing your stand relative to your competitors can help in your decision-making as well as interactions with suppliers and customers. It identifies areas where there is room for improvement, as well as areas where you can celebrate success.

Important financial ratios and numbers can help your management team pull in the same direction. Each owner and each business may have different numbers they consider important to the overall operations. We can help identify metrics you and your management can use to improve how you track your results.

Contact Whitehorn to learn more about other key metrics, how your business is performing and areas to help you manage your day to day operations.