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Principles of Finance

6.2 Operating Efficiency Ratios

Principles of Finance6.2 Operating Efficiency Ratios

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

By the end of this section, you will be able to:

  • Calculate accounts receivable turnover to assess a firm’s performance in managing customer receivables.
  • Evaluate management’s use of assets using total asset turnover and inventory turnover.
  • Assess organizational performance using days’ sales in inventory calculations.

Efficiency ratios show how well a company uses and manages its assets, one key element of financial health. Important areas of efficiency are the management of sales, accounts receivable, and inventory. A company that is efficient will usually be able to generate revenues quickly using the assets it has acquired. Let’s examine four efficiency ratios: accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory.

Accounts Receivable Turnover

For our discussion of financial statement analysis, we will look at Clear Lake Sporting Goods. Clear Lake Sporting Goods is a small merchandising company (a company that buys finished goods and sells them to consumers) that sells hunting and fishing gear. Figure 6.2 shows the comparative income statements and balance sheets for the past two years.

There are two comparative year end statements for Clear Lake Sporting Goods: the comparative year end income statements and the comparative year end balance sheets. The comparative year end income statements for Clear Lake Sporting Goods compares the prior year to the current year. Respectively, net sales are $100,000 and $120,000. Cost of goods sold is $50,000 and $60,000. Gross profit is $50,000 and $60,000. Rent expense is $5,000 and $5,500. Depreciation expense is $2,500 and $3,600. Salaries expense is $3,000 and $5,400. Utility expense is $1,500 and $2,500. Operating income is $38,000 and $43,000. Interest expense is $3,000 and $2,000. Income tax expense is $5,000 and $6,000. Net income is $30,000 and $35,000. The comparative year end balance sheets for Clear Lake Sporting Goods compares the prior year to the current year. Respectively, cash assets are $90,000 and $110,000. Accounts receivable assets are $20,000 and $30,000. Inventory assets are $35,000 and $40,000. Short-term investments are $15,000 and $20,000. Total current assets are $160,000 and $200,000. Equipment assets are $40,000 and $50,000. Total assets are $200,000 and $250,000. Respectively, accounts payable liabilities are $60,000 and $75,000. Unearned revenue liabilities are $10,000 and $25,000. Total current liabilities are $70,000 and $100,000. Notes payable liabilities are $40,000 and $50,000. Total liabilities are $110,000 and $150,000. Respectively, stockholder equity of common stock is $75,000 and $80,000, ending retained earnings are $15,000 and $20,000, total stockholder equity is $90,000 and $100,000, and total liability and stockholder equity is $200,000 and $250,000.
Figure 6.2 Comparative Income Statements and Year-End Balance Sheets Note that the comparative income statements and balance sheets have been simplified here and do not fully reflect all possible company accounts.

To begin an analysis of receivables, it’s important to first understand the cycles and periods used in the calculations.

Operating Cycle

A period is one operating cycle of a business. The operating cycle includes the cash conversion cycle plus the accounts receivable cycle (discussed below). Essentially it is the time it takes a business to purchase or make inventory and then sell it. For example, assume Clear Lake Sporting Goods orders and receives a shipment of fishing lures on June 1. It stocks the shelves with lures and tracks its inventory and sales. By July 15, all the lures from that shipment are gone. In this example, Clear Lake’s operating cycle is 45 days.

Cash Conversion Cycle

Cash, however, doesn’t necessarily flow linearly with accounting periods or operating cycles. The cash conversion cycle is the time it takes to spend cash to purchase inventory, produce the product, sell it, and then collect cash from the customer. Accounts receivable is one section of that cycle. Referring to Clear Lake’s June 1 shipment of lures that sold by July 15, assume that some of the customers were fishing guides that keep an open account with Clear Lake. This company did not pay for its lures until August 15 when it settled its account. In this example, Clear Lake’s cash cycle is 75 days.

Let’s take a look at the accounts receivable turnover ratio, which helps assess that element of the cash conversion cycle.

Accounts Receivable Turnover Ratio

Receivables ratios show company performance in relation to current receivables (what is due from customers), as well as credit policy effect on sales growth. One receivables ratio is called the accounts receivable turnover ratio.This ratio determines how many times (i.e., how often) accounts receivable are collected during a year and converted to cash. A higher number of times indicates that receivables are collected quickly. This quick cash collection may be viewed as a positive occurrence because liquidity improves, and the company may reinvest in its business sooner when the value of the dollar has more buying power (time value of money). The higher number of times may also be a negative occurrence, signaling that credit extension terms are too tight, and it may exclude qualified consumers from purchasing. Excluding these customers means that they may take their business to a competitor, thus reducing potential sales.

In contrast, a lower number of times indicates that receivables are collected at a slower rate. A slower collection rate could signal that lending terms are too lenient; management might consider tightening lending opportunities and more aggressively pursuing payment from its customers. The lower turnover also shows that the company has cash tied up in receivables longer, thus hindering its ability to reinvest this cash in other current projects. The lower turnover rate may signal a high level of bad debt accounts. The determination of a high or low turnover rate really depends on the standards of the company’s industry. It’s key to note the tradeoff in adjusting credit terms. Loose credit terms may attract more customers but may also increase bad debt expense. Tighter credit terms may attract fewer customers but may also reduce bad debt expense.

The formula for accounts receivable turnover is

Accounts Receivable Turnover = Net Credit SalesAverage Accounts ReceivableAccounts Receivable Turnover = Net Credit SalesAverage Accounts Receivable
Average Accounts Receivable = Beginning Accounts Receivable + Ending Accounts Receivable2Average Accounts Receivable = Beginning Accounts Receivable + Ending Accounts Receivable2

Net credit sales are sales made on credit only; cash sales are not included because they do not produce receivables. However, many companies do not report credit sales separately from cash sales, so “net sales” may be substituted for “net credit sales” in this case. Beginning and ending accounts receivable refer to the beginning and ending balances in accounts receivable for the period. The beginning accounts receivable balance is the same figure as the ending accounts receivable balance from the prior period.

When computing the accounts receivable turnover for Clear Lake Sporting Goods, let’s assume net credit sales make up $100,000 of the $120,000 of the net sales found on the income statement in the current year.

Average Accounts Receivable = $20,000 + $30,0002=$25,000Average Accounts Receivable = $20,000 + $30,0002=$25,000
Accounts Receivable Turnover=$100,000$25,000=4 timesAccounts Receivable Turnover=$100,000$25,000=4 times

To gain a better understanding of its ratio performance, Clear Lake Sporting Goods can compare its turnover to industry averages, key competitors, and its own historical ratios. Given this outcome, the managers may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts.

Think It Through

Accounts Receivable Turnover

You are a consultant assessing cash management practices for two firms, Company A and Company B (see Figure 6.3).

Financial Information for Company A and Company B. Respectively, the beginning accounts receivables are $50,000 and $60,000, ending accounts receivables are $80,000 and $90,000 and the Net Credit Sales are $550,000 and $460,000.
Figure 6.3 Financial Information for Company A and Company B

Based on the information provided, do the following:

  • Compute the accounts receivable turnover ratio.
  • Interpret the outcomes, indicating how each company is performing

Total Asset Turnover

Total asset turnover measures the ability of a company to use its assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is

Total Asset Turnover = Net SalesAverage Total AssetsTotal Asset Turnover = Net SalesAverage Total Assets
Average Total Assets =  Beginning Total Assets + Ending Total Assets2Average Total Assets =  Beginning Total Assets + Ending Total Assets2

Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year.

Clear Lake Sporting Goods’ total asset turnover is

Average Total Assets =$200,000 + $250,0002=$225,000Average Total Assets =$200,000 + $250,0002=$225,000
Total Asset Turnover = $120,000$225,000 = 0.53 times (rounded)Total Asset Turnover = $120,000$225,000 = 0.53 times (rounded)

The outcome of 0.53 means that for every $1 of assets, $0.53 of net sales are generated. Over time, Clear Lake Sporting Goods would like to see this turnover ratio increase.

Inventory Turnover

Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is

Inventory Turnover=Cost of Goods SoldAverage InventoryInventory Turnover=Cost of Goods SoldAverage Inventory
Average Inventory= Beginning Inventory + Ending Inventory2Average Inventory= Beginning Inventory + Ending Inventory2

Cost of goods sold for the current year is found on the income statement. Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year.

Clear Lake Sporting Goods’ inventory turnover is

Average Inventory = $35,000 + $40,0002=$37,500Average Inventory = $35,000 + $40,0002=$37,500
Inventory Turnover =$60,000$37,500=1.6 timesInventory Turnover =$60,000$37,500=1.6 times

A ratio of 1.6 times seems to be a very low turnover rate for Clear Lake Sporting Goods. This may mean the company is maintaining too high an inventory supply to meet a low demand from customers. Managers may want to decrease their on-hand inventory to free up more liquid assets to use in other ways. Keep in mind, ratios should not be taken out of context. One ratio alone can’t tell the whole story. Ratios should be used with caution and in conjunction with other ratios and additional financial and contextual information.

As with accounts receivable, there is a trade-off to consider in managing inventory. Low turnover will usually mean a low risk of stockouts and the ability to carry more of what customers are looking for. But high inventory levels will mean that more cash is tied up in inventory. High turnover will mean carrying less inventory and the higher risk of stockouts, causing customers to go elsewhere to find what they need.

Stack of inventory in a warehouse.
Figure 6.4 Inventory turnover can help determine how well a company manages its inventory. (credit: “Untitled” by Marcin Wichary/flickr, CC BY 2.0)

Days’ Sales in Inventory

Days’ sales in inventory expresses the number of days it takes a company to turn inventory into sales. The fewer the number of days, the more quickly the company can sell its inventory. The greater the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is

Days' Sales in Inventory=Ending InventoryCost of Goods Sold × 365Days' Sales in Inventory=Ending InventoryCost of Goods Sold × 365

Clear Lake Sporting Goods’ days’ sales in inventory is

Days' Sales in Inventory = $40,000$60,000 × 365=243 days (rounded)Days' Sales in Inventory = $40,000$60,000 × 365=243 days (rounded)

Depending on the industry, 243 days may be a long time to sell inventory. While industry dictates what is an acceptable number of days to sell inventory, 243 days is likely to be unsustainable long-term. Remember, it’s important to not take one ratio out of context. Review the ratio in conjunction with other ratios and other financial data. For example, we might review the days’ sales in inventory along with accounts receivable turnover for Clear Lake Sporting Goods relative to the industry average to get a better picture of Clear Lake’s performance in this area.

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