This is the number
of times accounts receivable, on average, are collected during a year. It also
expresses the quality of accounts receivable and the company’s ability to
collect them. Generally a higher turnover ratio is good, but again it might be
indicative of overly strict credit policy.
=
Credit Sales
Average Receivables
Accounts
Receivable Collection Period
Also called “Days
Sales Outstanding” is the average number of days lapsed for accounts receivable
to be converted into cash. This ratio calculates the relationship between net
accounts receivable and average daily sales.
=
Average Accounts Receivables
Credit Sales / 365
This ratio helps to
gauge the liquidity of accounts receivable and the ability of the company to
collect them from customers. It also provides information regarding the credit
policy and the quality of accounts receivable. For example, if the average
collection period is increasing over time, the company’s credit policy is
becoming lenient and is compromising liquidity of accounts receivables. There
must be a balance in the credit policy to avoid high bad debt and loss of
customers.
Inventory
Turnover
This shows the
relationship of how many times inventory was converted into sales.
=
Cost of Goods Sold
Average Inventory
Generally, a high
inventory turnover ratio is indicative of aggressive sales and lower capital
tied up in the inventory, which means lower implicit financing cost. High
inventory turnover might also mean under stocking which could lead to delay in
customer orders, and ultimately loss of customers. Higher ratio might also
indicate higher sales than expected and a shortage of inventories. On the other
hand, low inventory turnover represents weak inventory management system, slow
moving or obsolete inventory or excess storage of inventory resulting in high
carrying costs. Similarly, low inventory turnover might stem from further
increase in demand, or shortage of raw material. Analysts should further
investigate reasons for abnormally high or low inventory turnover.
One of the most
important things to consider is the type of industry in which the company is
operating. For example, a company which is involved in selling fresh fruits
(perishable item) has a higher turnover ratio than a company selling furniture
(non-perishable item).
Inventory
Turnover in Days
This shows the
ability of a firm to effectively manage inventory. It indicates the average
length of time inventory is held by the firm. Greater inventory turnover is a
sign of active business. However, over trading i.e. large volume of business
with a small asset base could show the same symptom.
=
Average Inventory
Cost of Goods Sold / 365
Payable Turnover
Period
Measures average
time taken by the company to settle the creditors. This is calculated in the
same manner as average collection period:
=
Average Accounts Payable
Cost of Goods Sold / 365
Credits are cost
free funds available to the organization and delaying payment is desirable.
However, it should not affect the company's image and it should be noted that
there could be penalties for late payment.
Total Asset
Turnover
Relates total assets
to sales. This ratio measures efficiency of the firm in utilizing the assets to
generate sales. Efficient management would make use of its assets to generate
maximum sales. However, it has to be cautioned that assets are shown at
historical cost and thus the ratio could mislead the analyst.
=
Sales
Total Assets
Operating Cycle
The length of time
taken from purchases of inputs to collection of receivables resulting from sales
is known as operating cycle. This is a useful concept as it gives a basic idea
of how long it takes to turn the raw materials into cash. A company which has a
shorter operating cycle has the capacity to turn raw materials into sales and
then into cash in a relatively shorter period and thus can operate with minimal
working capital.
=
Inventory Turnover in Days + Receivable Turnover in Days
Cash Cycle
The operating cycle
starts from the point of purchases of inputs irrespective of the actual payment
for such purchases. Cash cycle is the time length between actual outlay of cash
for purchases and collection of receivables resulting from sales. This is
arrived at by subtracting the time taken to settle the payables from the
operating cycle.
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