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Filed under Finance

Ask About Business Ratios -- Part Two

by Ratio Rookie | May 20, 2012

Subject :Accounting and Finances

Dear Toolkit,

I've heard that calculating "business ratios" from my financial statements would be helpful in running my store. What I haven't heard is why. Can you enlighten me?


Ratio Rookie

Dear Rookie,

As we described in Part One, there are four major groups of statistics that are most commonly used. These four categories are (1) liquidity ratios, which we covered in Part One, (2) efficiency ratios, (3) profitability ratios, and (4) solvency ratios.

Let's move on to Efficiency Ratios. These indicators will let you know how productively you're using your assets. Although larger businesses use a variety of asset-related measures, the two types of assets you'll most likely want to track are accounts receivable and inventory.

Receivables are sales for which you haven't been paid yet. Since this asset class is a principal source of cash inflow, monitoring your collection efficiency by use of ratios can give you a good feel for how your cash flow might be improved. Periodically calculating the average number of days it takes to collect receivables helps you monitor trends and increase your awareness of how much cash may be tied up in slow paying customer accounts. The less cash you invest in receivables (financing your customers), the more cash you'll be able to use to reduce debt or invest in higher yielding assets.

The average collection cycle is calculated by dividing your present accounts receivable balance by your average daily sales. Take your total sales for a given period (a year, a quarter, a month) and divide that number by the number of days in the period you chose. Then divide your accounts receivable balance from your current balance sheet by that average daily sales figure. The result will be the number of days your sales dollars are invested in receivables and not available for paying off your bills, meeting payroll, or investing in something more profitable.

Another way to monitor receivables is to calculate turnover. This ratio is found by dividing your sales for a particular period by your average accounts receivable balance over the same period. Say you had $24,000 in sales last quarter and your accounts receivable balance at the end of the 1st month was $7,000, the 2nd month $9,000 and the 3rd month $8,000, for an average receivable balance of $8,000 for that quarter. Your receivables turned over 3 times for that period—$24,000 divided by $8,000.

Now let's assume the next quarter you still had $24,000 in sales, but you did a better job of collecting receivables and your month-end average receivable balance for that quarter was $6,000. That would make your turnover rate 4 instead of 3 for the prior quarter. The higher the turnover, the better—because it indicates less time elapses between sales and collections.

A single period's results in "average collection time" (lower is better) or "turns" (higher is better) will seem simplistic and not very useful, but remember, you're looking for trends over longer periods of time. Noticing a bad trend early is the best way to head off big cash flow problems!

Inventory management is aided by using this same turnover tool. Inventory turnover is a ratio used in a manufacturing or retail business to let you know how fast your merchandise is moving. The ratio expresses the time frame between the acquisition of inventory and its sale. Inventory turnover is found by dividing cost of goods sold by average inventory.

Turnover analysis is the most basic and fundamental tool for controlling your investment in inventory. Turnover analysis looks at your business's investment in individual items or groups of items making up your entire inventory. From a cash flow perspective, performing turnover analysis is particularly useful for finding inventory items that are overstocked. Remember, an excessive investment in inventory results in less cash available for other cash outflow purposes, such as paying bills.

Since turnover analysis focuses on individual inventory items or groups of items, it requires that you make a periodic count of all the items making up your total inventory. For a look at how this is performed, see our case study.

Turnover analysis also requires that you know the number of inventory items sold on an individual basis. This may seem like a lot of work just to determine if the investment in a particular inventory item or group of items is excessive. However, the information provided by the analysis will make it all worthwhile.

The average inventory investment period measures the amount of time it takes to convert a dollar of cash outflow, used to purchase inventory, to a dollar of sales or accounts receivable from the sale of the inventory. The average investment period for inventory is much like the average collection period we discussed above for accounts receivable. A longer average inventory investment period requires a higher investment in inventory. A higher investment in inventory means less cash is available for other cash outflows, such as paying bills.

There are some limitations to the information provided by the average inventory investment calculation. First, as the name implies, the average inventory investment period is an "average." Because it is an average, it assumes that all products are the same, each selling at the same rate, and each costing the same amount. Secondly, the calculation assumes that your inventory only contains one product. Most likely, your business carries a number of different products—some selling faster than others, and others costing you more to purchase.

Turnover analysis goes beyond the average assumptions made by the average inventory investment period. It does this by requiring you to look at each product or line individually, taking into account the number currently on hand, the number sold, and the number on hand in relation to the rate at which each item sells. So, turnover analysis can be used to pinpoint the specific inventory items that are creating an excess investment in inventory, thus creating cash flow problems.

Practice figuring your efficiency ratios, don't forget to review your liquidity ratios and profitability ratios!