In this section, we will discuss five financial ratios which use an amount from the balance sheet and an amount from the income statement. Specifically, we will discuss the following:
- Ratio #10 Receivables turnover ratio
- Ratio #11 Days’ sales in receivables (average collection period)
- Ratio #12 Inventory turnover ratio
- Ratio #13 Days’ sales in inventory (days to sell)
- Ratio #14 Return on stockholders’ equity
The first four of the above ratios inform us about a company’s speed in:
- Collecting (turning over) its accounts receivable
- Selling (turning over) its goods in inventory
The speed at which a company is able to convert its accounts receivable and inventory into cash is crucial for the company to meet its payroll, pay its suppliers, and pay other current liabilities when the amounts are due. In other words, a company could have a huge amount of working capital and an impressive current ratio, but it requires that the current assets be converted to cash to pay the bills.
Therefore, a higher receivables turnover ratio (Ratio #10) and a higher inventory turnover ratio (Ratio #12) are better than lower ratios. These higher turnover ratios mean there will be less days’ sales in receivables (Ratio #11) and less days’ sales in inventory (Ratio #13). Having less days in receivables and inventory are better than a higher number of days.
Recall that the amounts reported on the balance sheet are as of an instant or point in time, such as the final moment of an accounting year. Therefore, a balance sheet dated December 31 provides a “snapshot” of the pertinent general ledger account balances (assets, liabilities, equity) as of the final moment of December 31.
Also recall that the income statement reports the cumulative amounts of revenues, expenses, gains, and losses that occurred during the entire 12 months that ended on December 31.
NOTE:
To overcome this mismatch of comparing an income statement amount (such as the cumulative sales for the entire year) to a balance sheet amount (such as the accounts receivable balance at the final moment of the year), we need the balance sheet amount to be an average amount that is representative of all the days during the year.
Graphing the daily (or perhaps weekly) balances during the year and then computing an average of those many data points will provide a representative average. Unfortunately, people outside of the company do not have access to those details.
As an alternative, outsiders often compute an average based on the end-of-the-year moment for the current year and the previous year. (They do this without regard to whether these end-of-the-year balances are much lower than the balances during the year.)
Ratio #10 Receivables Turnover Ratio
The receivables turnover ratio (or accounts receivable turnover ratio) relates a company’s net credit sales from the most recent year to the amount the customers owed the company during that year.
NOTE:
Net credit sales = gross credit sales (cash sales are excluded) minus any related sales discounts, sales returns, and sales allowances.
If a new startup company makes its first sale with credit terms of net 30 days, the company records the sale by increasing Accounts Receivable and increasing Sales on Credit. If the customer pays in 30 days, the company will increase Cash and will decrease Accounts Receivable. This means that the company will be turning over its receivables in 30 days. If that occurs with every sale, the receivables turnover ratio will be approximately 12.2 times per year (365 days / 30 days).
However, if all customers take 40 days to pay the amount owed, the receivables turnover ratio will be approximately 9.1 times per year (365 days / 40 days).
The higher the receivables turnover ratio, the faster the receivables are turning into cash (which is necessary for the company to pay its current liabilities on time). Therefore, a higher receivables turnover ratio is better than a lower ratio.
Some people categorize the receivables turnover ratio as an efficiency ratio since it indicates the speed in which the company had collected its accounts receivables and turned them into cash.
The receivables turnover ratio is calculated as follows:
Receivables turnover ratio = net credit sales for the year / average amount in accounts receivable
Example 10
Assume that a company competes in an industry where customers are given credit terms of net 30 days. Also assume that the company had $570,000 of net credit sales during the most recent year and on average it had accounts receivable during the year of $60,000.
Given this information, the company’s receivables turnover ratio is:
Receivables turnover ratio = net credit sales for the year / avg. amount of accounts receivable
Receivables turnover ratio = $570,000 / $60,000
Receivables turnover ratio = 9.5 times
To determine if this company’s receivables turnover ratio of 9.5 is acceptable or not acceptable, you could do the following:
- Look at the average receivables turnover ratio for the company’s industry
- Calculate a competitor’s receivables turnover ratio
- Compare it to the company’s past receivables turnover ratios
- Compare it to the expected ratio for the credit terms given to its customers
The larger the number of times that the receivables turn over during the year, the more often the company collects the cash it needs to pay its current liabilities.
NOTE:
If you are computing the receivables turnover ratio by using a corporation’s published (external) financial statements, you should be aware of the following:
Typically, the income statement does not report the amount of net credit sales as a separate amount. Instead, only the amount of net sales (credit sales + cash sales) will be available.
In our examples, we will provide the amount of a corporation’s net credit sales.
The balance sheet reports the corporation’s accounts receivable only at the final moment of the accounting year (and usually the balance at the final moment of the previous year). The average balance in accounts receivable throughout the year is not reported.
As a result, an average balance in accounts receivable must be calculated. Since people outside of the corporation do not have access to the daily, weekly, or monthly balances, they often calculate a simple average based on the two balances as of the final moment of each accounting year. (This average could be much lower than the balances throughout the year since U.S. corporations often end their accounting years when their business activity is at the lowest levels.)
In our examples, we will provide the average amount of a corporation’s accounts receivable throughout the accounting year.
Ratio #11 Days’ Sales in Receivables (Average Collection Period)
The days’ sales in receivables (also known as the average collection period) indicates the average amount of time it took in the past year for a company to collect its accounts receivable.
An easy way to determine the number of days’ sales in receivables is to divide 365 (the days in a year) by the receivables turnover ratio, which was explained in Ratio #10. In other words, the formula for the days’ sales in receivables is:
Days’ sales in receivables = 365 days / receivables turnover ratio
Example 11
Assume that a company had $570,000 of net credit sales during the most recent year. During the year it had an average of $60,000 of accounts receivable. As a result, its receivables turnover ratio was 9.5 times per year ($570,000 / $60,000).
Since the company’s receivables turnover ratio was determined to be 9.5, the days’ sales in receivables is calculated as follows:
Days’ sales in receivables = 365 days / receivables turnover ratio
Days’ sales in receivables = 365 days / 9.5
Days’ sales in receivables = 38.4 days
To determine whether this company’s days’ sales in receivables of 38.4 days is acceptable (or not acceptable), you could do the following:
- Look at the average receivables turnover ratio for the company’s industry
- Calculate a competitor’s receivables turnover ratio
- Compare it to the company’s past receivables turnover ratios
- Compare it to the expected ratio for the credit terms given to its customers
Having a smaller number of days’ sales in receivables means that on average, the company is converting its receivables into the cash needed to pay its current liabilities.
NOTE:
The days’ sales in receivables (such as the 38.4 days we just calculated) was based on all customers’ transactions and unpaid balances. It includes the credit sales made a few days ago, 25 days ago, 50 days ago, 75 days ago, etc. Therefore, the average of 38.4 could be concealing some slow-paying customers’ accounts.
Instead of using one of the receivables ratios, it would be better to have an aging of accounts receivable (which is readily available with accounting software). The aging of accounts receivable sorts each customer’s unpaid balance into columns which have headings such as: Current, 1-30 days past due, 31-60 days past due, 61-90 days past due, 91+ days past due. This aging report allows a company’s personnel to see the exact amount(s) owed by each customer. As a result, the company can take action to collect the past due amounts.
Ratio #12 Inventory Turnover Ratio
The inventory turnover ratio indicates the speed at which a company’s inventory of goods was sold during the past year. Since inventory is reported on a company’s balance sheet at its cost (not selling prices), it is necessary to relate the inventory cost to the cost of goods sold (not sales) reported on the company’s income statement.
Since the cost of goods sold is the cumulative cost for all 365 days during the year, it is important to relate it to the average inventory cost throughout the year.
Because a company’s published balance sheet reports only the inventory cost at the final moment of the accounting year and the final moment of the prior accounting year, the average of these two data points may not be representative of the inventory levels throughout the 365 days of the year. (The reason is that many U.S. corporations end their accounting year at the lowest levels of activity.) In our examples, we will provide you with the company’s average cost of inventory that is representative of the entire year.
Here is the formula for the inventory turnover ratio:
Inventory turnover ratio = cost of goods sold for the year / average cost of inventory during the year
Since there are risks and costs associated with holding inventory, companies strive for a high inventory turnover ratio, so long as its inventory items are never out of stock.
Example 12
Assume that during the most recent accounting year, a company had sales of $420,000 and its cost of goods sold was $280,000. Also assume that the company’s balance sheet at the end of the year reported the cost of its inventory as $75,000 and was $65,000 at the end of the previous year. An analysis of the company’s inventory records indicates that inventory cost increased steadily throughout the year. Based on the analysis, the average inventory cost during the accounting year was determined to be $70,000. Given this information, the company’s inventory turnover ratio for the recent accounting year was:
Inventory turnover ratio = cost of goods sold for the year / avg. cost of inventory during the year
Inventory turnover ratio = $280,000 / $70,000
Inventory turnover ratio = 4 times in the year
To determine whether this company’s inventory turnover ratio of 4 is acceptable or not acceptable, you could do the following:
- Look at the average inventory turnover ratio for the company’s industry
- Calculate a competitor’s inventory turnover ratio
- Compare it to the company’s past inventory turnover ratios
- Compare it to the expected inventory turnover ratio
The inventory turnover ratio is an average of perhaps hundreds of different products and component parts carried in inventory. Some items in inventory may not have had any sales in more than a year, some may not have had sales in six months, some may sell within weeks of arriving from the suppliers, etc.
Here’s a Tip
Rather than relying on the average turnover ratio for the entire inventory, a company’s managers could calculate a turnover ratio for each product it has in inventory. For example, the average quantity/units of its Item #123 in inventory would be compared to the quantity/units of Item #123 that were sold during the year.
A simple worksheet would list every item in inventory and then calculate each item’s approximate inventory turnover ratio. The formula is: the number of units sold during the past year / the number of units in inventory. The slow-moving items (those with low inventory turnover ratios) would then be reviewed to determine whether it is profitable to continue carrying these items.
An additional column could be added to the worksheet to show the days’ sales in inventory (Ratio #13 which follows).
Ratio #13 Days’ Sales in Inventory (Days to Sell)
The days’ sales in inventory (also known as days to sell) indicates the average number of days that it took for a company to sell its inventory. The goal is to have the fewest number of days of inventory on hand because of the high cost of carrying items in inventory (including the risk of items spoiling or becoming obsolete). Of course, there is also a cost for being out of stock. Therefore, managing inventory levels is important.
An easy way to calculate the number of days’ sales in inventory is to divide 365 (the days in a year) by the inventory turnover ratio (Ratio #12).
Here is the formula for calculating the days’ sales in inventory:
Days’ sales in inventory = 365 days / inventory turnover ratio
Example 13
Assume that a company’s cost of goods sold for the year was $280,000 and its average inventory cost for the year was $70,000. Therefore, its inventory turnover ratio was 4 times during the year ($280,000 / $70,000).
Given that the company’s inventory turnover ratio was 4, the days’ sales in inventory is calculated as follows:
Days’ sales in inventory = 365 days / inventory turnover ratio
Days’ sales in inventory = 365 days / 4
Days’ sales in inventory = 91.25 days
A smaller number of days’ sales in inventory is preferred, since it indicates the company will be converting its inventory to cash sooner. (It may get cash immediately for cash sales, or it will get cash when the resulting receivables are collected.)
The days’ sales in inventory is an average of the many products that a company had in inventory. Some of the products may not have been sold in more than a year, some may not have been sold in 10 months, some were sold shortly after arriving from the suppliers, etc.
Since we used the inventory turnover ratio to calculate the days’ sales in inventory, a mistake in calculating the inventory turnover ratio will result in an incorrect number of days’ sales in inventory. (For instance, if someone uses sales instead of the cost of goods sold to calculate the inventory turnover ratio, the days’ sales in inventory will not be accurate.)
Ratio #14 Return on Stockholders’ Equity
For a corporation that has only common stock (no preferred stock) outstanding, the return on stockholders’ equity is calculated by dividing its earnings (net income after tax) for a year by the average amount of stockholders’ equity during the same year.
The amount of stockholders’ equity reported on a corporation’s balance sheet is the amount as of the final moment of the accounting year. On the other hand, the net income after tax is the cumulative amount earned throughout the entire year. Therefore, the calculation of the return on stockholders’ equity ratio should use the average amount of stockholders’ equity throughout the year.
The formula for the annual return on stockholders’ equity for a corporation with only common stock is:
Return on stockholders’ equity = net income after tax / average stockholders’ equity
Example 14
Assume that during the past year a corporation had net income after tax (earnings) of $560,000. It was determined that a representative average amount of stockholders’ equity during the year was $2,800,000. Given this information, the corporation’s return on stockholders’ equity for the past year was:
Return on stockholders’ equity = net income after tax / average stockholders’ equity
Return on stockholders’ equity = $560,000 / $2,800,000
Return on stockholders’ equity = 20%
To determine whether a corporation’s return on stockholders’ equity is reasonable, you could do the following:
- Look at the average return on stockholders’ equity for the corporation’s industry
- Calculate a competitor’s return on stockholders’ equity
- Compare it to the corporation’s return on stockholders’ equity in recent years
- Compare it to the planned return on stockholders’ equity
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