Tried-and-True Financial Ratios Can Be Key to Healthy Firm
In Aesop’s fable, the tortoise and the hare stage a footrace, and the tortoise, moving at a steady pace, wins. The hare, so enamored of his speed that he naps along the way, awakes to discover that he can’t catch up.
It is different in business: Success visits the disciplined and the flashy alike, but the flashy need more than alertness to succeed. They need luck. The disciplined succeed because they wring value out of the humdrum--for example, out of two humble financial ratios called inventory turnover and accounts receivable.
Beloved by accountants and often mysterious to business owners, these ratios can prove key to the health of your company. If you understand them and make use of what they say about your operations, you rely on neither flash nor luck to get to prosperity but rather on the tried and true.
What do these financial ratios measure? How can you make use of them?
The inventory turnover ratio measures the speed with which you turn your goods into sales. The accounts receivable ratio measures the speed with which you turn those sales into cash.
In both cases, faster means better: The more often you turn over your inventory and the faster you collect on your accounts receivables, the better your cash flow--and cash flow, as outlined in this space in recent weeks, is the lifeblood of your business.
Put another way, good ratios for inventory turnover and accounts receivable make for profitable operations and lead to steady if unspectacular growth. You hit singles and occasionally doubles, not home runs, with improvements in these ratios--a good strategy given the difficulty of finding capital for aggressive growth.
The inventory turnover ratio is important to businesses that sell goods--manufacturers, wholesalers, retailers. The accounts receivable ratio is important to businesses that sell goods or services on account--manufacturers, wholesalers, some service businesses.
To calculate your inventory turnover ratio, you take the beginning and ending inventory figures from your balance sheet, add them together, and divide by two. The result is the average value of your inventory for the period in question--say, one year.
You divide the result into your cost of goods sold, taken from your profit-and-loss statement. The answer tells you how often you turn over your inventory in the period. In general, a high number is better than a low.
For example, if your balance sheet for the year shows a beginning inventory of $1 million and an ending inventory of $2 million, the average is $1.5 million.
You divide the average, $1.5 million, into your cost of goods sold--say, $4.5 million--and get 3. The answer tells you that in the year in question, you turned inventory over three times.
Next you divide this number into 365--the number of days in a year. The answer tells you that, on average, it takes about 121 days to sell your inventory.
Similarly, to get your accounts receivable ratio for the same year, you take the beginning and ending figures for your accounts receivable from your balance sheet, add them together, and divide by two. The result is the average of your accounts receivable for the year.
You divide the result into the total of your net sales made on account for the period--that is, sales made on terms other than cash, less any allowances for returns or discounts. The answer tells you how long it takes to collect your receivables for the year.
For example, if your balance sheet shows beginning and ending figures for accounts receivable of $400,000 and $600,000, the sum is $1 million and the average is $500,000.
You divide this figure into the total sales made on account--say, $5 million. You divide the result, 10, into 365. The answer tells you that it takes about 36 days on average to collect your receivables.
Why are these ratios important?
“The accounts receivable turnover ratio is important because if you can collect on your billings quickly, you can pay your own bills in a timely manner,” says Michael Manis, associate professor of business at the College of the Desert in Palm Desert.
“And if you make your creditors happy, you might get favored treatment, perhaps a trade discount, that can enhance your profitability,” he said.
Similarly, the faster you turn over your inventory, the more you free up cash to make or buy more inventory and make more sales, Manis says. Put another way, a rapid turnover also makes for more-profitable operations.
Manis adds that it’s important to compare the numbers you get with the norms for your industry--available from trade associations--and to study the numbers produced by your own business cycles over several years, probing for trends and their causes alike.
With this information, you can do your planning for the next year with specific goals in mind for both inventory and accounts receivable--and have a mechanism to measure the improvement in both ratios.
The aim, he says, is to speed cash inflows, because even small improvements can make a difference in the bottom line.
“Cash allows you to improve your operations,” Manis says. “If you’re flush and you need office supplies, you can take advantage of a sale that comes along or of a special offer from a supplier who has excess inventory and will discount it for cash.
“If you speed inventory and accounts receivable turnover, you maximize cash flow,” Manis says. “You don’t want cash tied up in inventory or in receivables. You want to get inventory out the door quickly--and get cash in the door just as quickly.”
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Columnist Juan Hovey may be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.
