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Understanding Activity Ratios
Understanding activity ratios is a very important tool for evaluating a company’s performance. Whether interpreting your company’s financial ratios or evaluating another company, it’s important to understand what activity ratios indicate about the company’s performance. Activity ratios are often referred to as efficiency ratios because they measure how efficiently a company is managing its assets. Activity ratios can be divided into two categories; Turnover ratio and days on hand.
Accounts receivable ratio
Accounts Receivable Turnover = Net Sales ÷ Net accounts receivable
The accounts receivable turnover ratio measures how often, on average, accounts receivable are collected in cash or “turnover” during a fiscal year.
Accounts Receivable Days on Hand = Net Accounts Receivable ÷ Net sales X 365
Accounts receivable days on hand (ARDOH) is the average number of days required to convert receivables into cash. Accounts receivable days measure a company’s ability to collect from customers. This number should be compared with the company’s stated credit terms. By comparing these numbers to previous years, we can determine if there is an identifiable trend in accounts receivable. An increase in ARDOH may mean that the company has increased credit terms in an effort to increase sales, or poor accounts receivable management. As a rule, the upper acceptable limit for the firm’s average collection period should be 50% more than the stated conditions. For example, if a company states terms of 30 days, the upper limit would be 45 days. More than 45 days would be cause for concern. If the A/R days are less than the specified terms then the company is doing an excellent job of collecting receivables. If the A/R days are more than the stated credit terms, the management may have to tighten the credit for the lesser receivables.
The A/R days on hand ratio is extremely important because it allows us to put the company’s accounts receivable balance, from the balance sheet, into perspective. If a company has $1,000,000 in accounts receivable, my look looks good when I look at the balance sheet, but if we find that A/R days are greater than the company’s stated credit terms, we have to question how much of that $1,000,000 is there. In this case of collectibles, you’ll want to look at accounts receivable aging to determine how much is uncollectible.
Inventory turnover = cost of goods sold ÷ Inventory
Inventory turnover measures the average number of times inventory is sold during the year.
Inventory Days on Hand = Inventory ÷ Cost of goods sold X 365
Inventory days on hand measures how many days a company has inventory on hand. Inventory days on hand should be compared to previous years to determine trends affecting inventory and industry averages. A high number may indicate poor inventory management or obsolete, unmarketable, or stale inventory. For example, if a company’s inventory days are 70 days in year 1 and increase to 90 days in year 2, the company needs to understand why there is a large jump in inventory days on hand. There are many possible causes of slack, such as increased inventory in anticipation of future shortages, obsolete or stale inventory, or poor inventory management. However, if 90 days is the industry average, the jump may not be a major cause for concern. Management must be questioned to understand why the days of inventory on hand changed.
Accounts Payable Ratio
Accounts Payable Turnover = Cost of Goods Sold ÷ Accounts Payable
The accounts payable turnover ratio measures how often, on average, accounts receivable are collected for cash, inventory is sold, and accounts payable are paid during the year.
Accounts Payable Days on Hand = Accounts Payable ÷ Cost of goods sold X 365
Accounts Payable is the average number of days it takes to pay in cash. This ratio gives an insight into the payment pattern of the company. This should be measured according to the terms offered by the suppliers to the company. If the number is higher than the terms offered by the suppliers, it may be a cause for concern as the suppliers may require cash on delivery. However, fewer accounts payable days lengthen the operating cycle and may lead to the need for outside financing.
Another useful tool for evaluating a company’s performance is calculating the operation cycle.
Operating cycle = A/R days on hand + Inventory days – A/P days on hand
It is important to understand the relationship these three ratios have on a company’s cash flow. The operating cycle is determined by adding the A/R days on hand and the inventory days on hand and subtracting the A/P days. Simply put, the operating cycle is the time it takes for a company to purchase and produce goods, pay for goods, sell goods, and receive cash for the goods sold. If a company experiences an increase in A/R days on hand or inventory days, while A/P days remain constant, their need for outside financing will increase.
An understanding of activity ratios is essential to assess the efficiency and effectiveness of a company. It is important to understand how changes in A/R days, inventory days on hand, and A/P days can affect a company’s operating cycle. Business owners, managers, and investors can all benefit from a solid understanding of activity ratios.
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