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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 is essential to understand what activity ratios indicate about a company’s performance. Activity ratios are often referred to as efficiency ratios because they measure how efficiently the business manages its assets. Activity ratios can be divided into two categories; turnover ratios and working day ratios.
Accounts Receivable Ratios
Accounts Receivable Revenue = Net Sales ÷ Net accounts receivable
The accounts receivable turnover ratio measures how many times, on average, accounts receivable are collected in cash, or “turns,” during the fiscal year.
Accounts receivable on hand = Net accounts receivable ÷ Net Sales X 365
Accounts Receivable Days Available (ARDOH) is the average number of days it takes to convert receivables into cash. Accounts receivable balance days measure a company’s ability to collect from its customers. This number should be compared to the credit terms stated by the company. By comparing this number to previous years, we can determine if there is an identifiable trend in accounts receivable. An increase in ARDOH could mean that the company increased credit terms in an effort to increase sales or mishandled accounts receivable. As a general rule, the acceptable upper limit for a company’s average payback period should be 50% above the stated terms. For example, if a company listed 30-day terms, the upper limit would be 45 days. Anything over 45 days would be a concern. If the days of available accounts receivable are less than the stated terms, a company is doing a great job of collecting receivables. If available customer account days exceed stated credit terms, management may need to tighten credit to reduce receivables.
The A/R up-days ratio is extremely important because it allows us to put a company’s accounts receivable balance into perspective, from the balance sheet. If a business has $1,000,000 in accounts receivable, which I’m looking at fine just by glancing at the balance sheet, however if we find out that the available A/R days are way above the stated credit terms of the business, we should ask ourselves how much of that $1,000,000 is really collectible. In this case, you would want to see an aging of accounts receivable to determine how much is likely uncollectible.
Inventory turnover = cost of goods sold ÷ Inventory
Inventory turnover measures how many times, on average, inventory is sold during the year.
Inventory Days Available = Inventory ÷ Cost of Goods Sold X 365
Days of inventory available measures the number of days of inventory a business has at any given time. Days of inventory available should be compared to previous years to determine trends affecting inventory and the industry average. Too high a number may indicate poor inventory management or an obsolete, unsaleable, or obsolete inventor. For example, if a company’s days of stock on hand are 70 days in year one and increase to 90 days in year two, the company needs to understand why there has been a dramatic increase in days of stock on hand. . There can be many probable reasons for the slowdown, such as an increase in inventory in anticipation of a future shortage, obsolete or obsolete inventory, or poor inventory management. However, if 90 days is the industry average, the jump may not be a major cause for concern. It would be necessary to interview management to help understand why available inventory days have changed.
Accounts payable ratios
Accounts Payable Revenue = Cost of Goods Sold ÷ Accounts payable
Accounts payable turnover ratios measure how often, on average, accounts receivable is collected in cash, inventory is sold, and accounts payable is paid during the year.
Accounts Payable Days on Hand = Accounts Payable ÷ Cost of Goods Sold X 365
Accounts payable days on hand is the average number of days it takes to settle accounts payable in cash. This ratio provides insight into a company’s payment habits. This should be measured against the terms offered to a company by its suppliers. If the number is higher than the terms offered by the suppliers, this may be of concern as the suppliers may require cash on delivery. However, a low number of days of accounts payable increases the operating cycle and can lead to the need for external financing.
Another useful tool for evaluating the efficiency of a business is the calculation of the operating cycle.
Operating Cycle = A/R Days On Hand + Inventory Days On Hand – A/P Days On Hand
It is important to understand the relationship these three ratios have in affecting 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 on hand. Simply put, the cash cycle is the time it takes for a business to buy and manufacture goods, pay for goods, sell goods, and receive cash for items sold. If a company experiences an increase in available A/R days or available inventory days, while available A/P days remain constant, it will increase its need for external financing.
Understanding activity ratios is essential for evaluating a company’s performance and efficiency. It is important to understand how a change in A/R Days Available, Inventory Days Available, and A/P Days can affect a business’s operating cycle. Business owners, managers, and investors can all benefit from a solid understanding of business ratios.
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