There are certain financial ratios you need to watch closely during a—global or company—crisis. What ratios? You asked. Among many items in a company’s assets, cash is the most sensitive one to even a small crisis. Cash is the blood of company’s operation—basically no business will run smoothly if there is no enough cash available for its operation. Therefore, watching the cash availability is super important for any of us in the financial and accounting department.
Keeping some cash reserves are always a good strategy. But, in such crisis you won’t have enough cash excesses for any reserves—otherwise we don’t call it crisis. So, forget about cash reserve. Another good way to make sure that you have enough cash for company’s operation is by watching some specific ratios. Ratios that enable you to determine how quickly various accounts are converted into sales or cash. Liquidity ratios?
Not really. Overall liquidity ratios generally do not give an adequate picture of a company’s real liquidity, due to differences in the kinds of current assets and liabilities the company holds. What you have to do is to evaluate the activity or liquidity of specific current accounts: receivables and inventory, and cash—perform ratio analyses related to those accounts.
1. Accounts Receivable Ratios
Accounts receivable ratios consist of the accounts receivable turnover ratio and the average collection period. The accounts receivable turnover ratio gives the number of times accounts receivable is collected during the year.
It is found by dividing net credit sales (if not available, then total sales) by the average accounts receivable. Average accounts receivable is typically found by adding the beginning and ending accounts receivable and dividing by 2.
Although average accounts receivable may be computed annually, quarterly, or monthly, the ratio is most accurate when the shortest period available is used.
In general, the higher the accounts receivable turnover, the better since the company is collecting quickly from customers and these funds can then be invested. However, an excessively high ratio may indicate that the company’s credit policy is too stringent, with the company not tapping the potential for profit through sales to customers in higher risk classes (Note: Before changing its credit policy, a company has to weigh the profit potential against the risk inherent in selling to more marginal customers.
Here is the formula:
Accounts receivable turnover = net credit sales / average accounts receivable
Say, Lie Dharma Company’s average accounts receivable for 2010 is: ($15,000 + $20,000) / 2 = $17,500. And the accounts receivable turnover ratio for 2011 is: $80,000 / $17,500 = 4.57 times. If in 2010, the accounts receivable turnover ratio was 8.16. The drop in this ratio in 2011 is significant and indicates a serious problem in collecting from customers. The company needs to reevaluate its credit policy, which may be too lax, or its billing and collection practices, or both.
The collection period (days sales in receivables) is the number of days it takes to collect on receivables, with the following formula:
Average collection period = 365 / accounts receivable turnover
Therefore, the Lie Dharma Company’s average collection period for 2011 is: 365 / 4.57 = 79.9 days. This means that it takes almost 80 days for a sale to be converted into cash. In 2010, the average collection period was 44.7 days. With the substantial increase in collection days in 2011, there exists a danger that customer balances may become uncollectible!
One possible cause for the increase may be that the company is now selling to highly marginal customers. The analyst should compare the company’s credit terms with the extent to which customer balances are delinquent. An aging schedule, which lists the accounts receivable according to the length of time they are outstanding, would be helpful for this comparison.
The Lie Dharmas Company reports the following data relative to accounts receivable:
Average accounts receivable $ 400,000 $ 416,000
Net credit sales $2,600,000 $3,100,000
If the terms of sale are net 30 days, what is the accounts receivable turnover and the collection period?
Accounts receivable turnover:
= net credit sales / average accounts receivable
For 2010: $2,600,000 / $400,000 = 6.5 times
For 2009: $3,100,000 / $416,000 = 7.45 times
Collection period = 365 / accounts receivable turnover
For 2010: 365 / 6.5 = 56.2 days
For 2009: 365 / 7.45 = 49 days
What does this mean?
Okay. The company’s management of accounts receivable is poor. In both years, the collection period exceeded the terms of net 30 days. The situation getting worse, as is indicated by the significant increase in the collection period in 2010 relative to 2009. The company has significant funds tied up in accounts receivable that otherwise could be invested for a return. A careful evaluation of the credit policy is needed; perhaps too many sales are being made to marginal customers.
2. Inventory Ratios
If a company is holding excess inventory, it means that funds which could be invested elsewhere are being tied up in inventory. In addition, there will be high carrying cost for storing the goods, as well as the risk of obsolescence. On the other hand, if inventory is too low, the company may lose customers because it has run out of merchandise. Two major ratios for evaluating inventory are inventory turnover and average age of inventory.
Inventory turnover is computed as:
Inventory turnover = cost of goods sold / average inventory
Note: Average inventory is determined by adding the beginning and ending inventories and dividing by 2.
Say, for the Lie Dharma Company, the inventory turnover in 2011 is: $50,000 / $47,500 = 1.05 times. In 2010, the inventory turnover was 1.26 times.
The decline in the inventory turnover indicates the stocking of goods. An attempt should be made to determine whether specific inventory categories are not selling well and if this is so, the reasons therefore. Perhaps there are obsolete goods on hand not actually worth their stated value.
However, a decline in the turnover rate would not cause concern if it were primarily due to the introduction of a new product line for which the advertising effects have not been felt yet.
Average age of inventory is computed as follows:
Average age of inventory = 365 / inventory turnover
The average age of inventory in 2011 is: 365 / 1.05 = 347.6 days. In 2010, the average age was 289.7 days. The lengthening of the holding period shows a potentially greater risk of obsolescence.
Inventory Ratio Case Example:
On January 1, 2011, the Lie Dharma Company’s beginning inventory $400,000. During 2011, Lie Dharma purchased $1,900,000 of additional inventory. On December 31, 2011, Lie Dharma’s ending inventory was $500,000.
What is the inventory turnover and the age of inventory for 2011?
Step-1. Determine the cost of goods sold:
Beginning inventory $ 400,000
Cost of goods available $2,300,000
Ending inventory 500,000
Cost of goods sold $1,800,000
Step-2. Average inventory:
= [beginning inventory / ending inventory] / 2
= [$400,000 + $500,000] / 2
Step-3. Inventory turnover:
= cost of goods sold / average inventory
= $1,800,000 / $450,000
Step-4. Average age of inventory:
= 365 / inventory turnover = 365 / 4 = 91.3 days
What does this mean?
Okay. Say, the inventory turnover in 2010 was 3.3 and the average age of the inventory was 100.6 days, means Lie Dharma Company’s inventory management improved in 2011, as evidenced by the higher turnover rate and the decrease in the number of days that inventory was held.
As a result, there is less liquidity risk and the company’s profitability will benefit from the increased turnover of merchandise. Note that this is only a conjecture, based on an evaluation of two ratios in isolation; keep in mind that if the rapid turnover was accomplished by offering excessive discounts, for example, profitability ratios may not show an improvement.
3. Operating Cycle
The operating cycle of a business is the number of days it takes to convert inventory and receivables to cash. Hence, a short operating cycle is desirable.
The formula is:
Operating cycle = average collection period + average age of inventory
Say, the operating cycle for the Ratio Company in 2011 is: 79.9 days + 347.6 days = 427.5 days. If in 2010 the operating cycle was 334.4 days, this is an unfavorable trend since an increased amount of money is being tied up in noncash assets.
Operating Cycle Case Example
Based on the last case example of the inventory, what is the Lie Dharma Company’s operating cycle in 2011 if it is assumed that the average collection period is 42 days?
Average age of inventory = 91.3
Average collection period = 42.0
Operating cycle = 133.3 days
4. Cash Conversion Cycle
Noncash working capital consists of current assets and liabilities other than cash. One way to view noncash working capital efficiency is to view operations as a cycle—from initial purchase of inventory to the final collection upon sale. The cycle begins with a purchase of inventory on account followed by the account payment, after which the item is sold and the account collected. These three balances can be translated into days of sales and used to measure how well a company efficiently manages noncash working capital.
This measure is termed the cash conversion cycle or cash cycle. This is the number of days that pass before we collect the cash from a sale, measured from when we actually pay for the inventory.
The cash conversion cycle formula is:
Cash conversion cycle = operating cycle - accounts payable period
Accounts payable period = 365 / accounts payable turnover
Accounts payables turnover = cost of goods sold / average accounts payable
In 2011, Accounts payables turnover = $50,000 / ($50,400 + $50,000)/2 = 0.95 times, and accounts payable period = 365 / 0.95 = 384.2 days (Note that current liabilities for the Ratio Company are all accounts payable.). If in 2011 for the Ratio Company, the cash conversion cycle = 427.5 days - 384.2 days = 43.3 days. Thus, on average, there is a 43-day delay between the time the company pays for merchandise and the time it collects on the sale. In 2010, the ratio was 25.1 days.
This is an unfavorable sign since an increased cycle implies that more money is being tied up in inventories and receivables.
Operating and Cash Conversion Cycles Case Example
Consider the following selected financial data for the Putra Retailer:
Item Beginning Ending
Inventory $5,000 $7,000
Accounts receivable 1,600 2,400
Accounts payable 2,700 4,800
Net credit sales $50,000
Cost of goods sold 30,000
What is Putra Retailer’s ‘operating and cash conversion cycles’?
Step-1. Calculate three turnover ratios, as follows:
Average inventory turnover = $30,000 / [(5,000 + 7,000) / 2] = 5 times
Average receivable turnover = $50,000 / [(1,600 + 2,400) / 2] = 25 times
Average payable turnover = $30,000 / [(2,700 + 4,800 / 2] = 8 times
Step-2. Calculate three average periods, as follows:
Average age of inventory = 365/5 = 73 days
Average collection period = 365/25 = 14.6 days
Average payable period = 365/8 = 45.6 days
The time it takes to acquire inventory and sell it is about 73 days. Collection takes another 14.6 days, and the operating cycle is thus 73 + 14.6 =87.6 days. Therefore, the cash conversion cycle is 87.6 days less 45.6 days = 42 days.
Another two important ratios you need to watch closely are:
5. Total Asset Turnover
The total asset turnover ratio is helpful in evaluating a company’s ability to use its asset base efficiently to generate revenue. A low ratio may be due to many factors, and it is important to identify the underlying reasons. For example, is investment in assets excessive when compared to the value of the output being produced? If so, the company might want to consolidate its present operation, perhaps by selling some of its assets and investing the proceeds for a higher return or using them to expand into a more profitable area.
The total asset turnover formula is = net sales / average total assets
Say, in 2011 the total asset turnover ratio for the Lie Dharma Company is: $80,000 / $210,000 = 0.381. If in 2010, the ratio was 0.530 ($102,000/$192,500), means the company’s use of assets declined significantly, and the reasons need to be pinpointed. For example, are adequate repairs being made? Or are the assets getting old and do they need replacing?
6. Interrelationship of Liquidity and Activity to Earnings
A trade-off exists between liquidity risk and return. Liquidity risk is minimized by holding greater current assets than noncurrent assets. However, the rate of return will decline because the return on current assets (i.e., marketable securities) is typically less than the rate earned on productive fixed assets. Also, excessively high liquidity may mean that management has not aggressively searched for desirable capital investment opportunities.
Maintaining a proper balance between liquidity and return is important to the overall financial health of a business. It must be pointed out that high profitability does not necessarily infer a strong cash flow position. Income may be high but cash problems may exist because of maturing debt and the need to replace assets, among other reasons. For example, it is possible that a growth company may experience a decline in liquidity since the net working capital needed to support the expanding sales is tied up in assets that cannot be realized in time to meet the current obligations.
The impact of earning activities on liquidity is highlighted by comparing cash flow from operations to net income. If accounts receivable and inventory turn over quickly, the cash flow received from customers can be invested for a return, thus increasing net income.
One Final Note
Some people may think financial ratio is just a number, number is number—there is nothing to do with the business. That is quiet true if you think that computing and getting the financial ratios is the end of the road. Getting number is just the end of your road to get the tools. The real works is right after getting the tools: Once a ratio is computed, it should be compared with related ratios of the company, the same ratios from previous years, and the ratios of competitors.
The comparisons show trends over a period of time and hence the ability of an enterprise to compete with others in the industry. Ratio comparisons do not mark the end of the analysis of the company, but rather indicate areas needing further attention. If you are a controller, your road is even longer if the ratios show some serious issues—you would need to fix and solve the problems. And to do that, you would need more than numbers—some sound financial strategies.