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Operating Performance Ratios

Knowledge of these Activity Ratios will help understand the ability of companies to convert assets into sales in the earliest time.

Gopal Kavalireddi
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Operating performance ratios also called as Activity Ratios, measure the efficiency and effectiveness of a company in using its assets on the balance sheet for conversion to revenue, in other words, the operational performance of the company. The efficiency is determined by the ability to convert all its available assets into sales, in the earliest possible time. Inventory turnover, receivables turnover, payables turnover, working capital turnover, fixed asset turnover, total asset turnover etc. are some of the ratios which aid in measuring the overall operational performance of any company.

 

Inventory Turnover Ratio (InTR)

The number of times a company sells its inventory over a certain period is termed as inventory turnover and the ratio depicting the total sales to its average inventory is termed as the Inventory Turnover Ratio.

Inventory turnover ratio is calculated as:

InT Ratio = Total Sales / Average Inventory for the period, where

Average Inventory for the period = (Beginning Inventory + Closing Inventory) / 2

A higher inventory ratio indicates that the company is efficient in managing its inventories. This ratio helps in understanding if the business has an excessive inventory in relation to its sales position, which can indicate either unexpectedly low sales or poor inventory planning.

It is also important to understand that the inventory level can be affected or misleading due to reasons of seasonality, push-pull system of manufacturing, product obsolescence and discounts, as well as accounting practices. Hence, to avoid the influence of these factors and for greater accuracy, many analysts consider cost of goods sold instead of total sales for computational purposes.

InT Ratio = Cost of Goods Sold / Average Inventory for the Period

A low rate of inventory turnover can imply a flawed purchasing policy with high volume (bulk) purchases, or that inventory increased in anticipation of sales did not materialize over that period of time. At the same time, a high rate of inventory turnover might not simply imply a closely managed purchasing system. This might be even due to low cash reserves, restricting the company’s ability to maintain an average inventory level, and so is not prepared for capturing prospective sales. This scenario is possible when the company has high debt and low cash reserves.

 

Days Inventory Outstanding (DIO)

Also referred to as Days Inventory or the Days in Inventory or Inventory Turnover in Days, Days Inventory Outstanding is a measure identifying the company’s performance in selling the inventory and realizing the sales. It is an apt measure of the number of days taken from creation of inventory including work in progress into realizable sales.

Days Inventory Outstanding is calculated as:

DIO = Number of Days * Average Inventory / Cost of Goods Sold

and can also be expressed as, DIO = 365 Days / Inventory Turnover Ratio

A lower DIO is preferable for a company, as it indicates conversion of the inventory, which is a part of the current assets, into cash within a short time period. The DIO is one such efficiency parameter, with the usage and holding period of the inventory playing a major role in determining the final outcome. Also, as defined in the inventory turnover ratio, rather than total sales, the cost of goods sold has to be selected for accuracy of the computation.

 

Accounts Receivable Turnover Ratio (ARTR)

Also referred to as the Debtor’s Turnover Ratio, the Accounts Receivable Turnover Ratio is an accounting measure highlighting the company’s efficiency of extending credit and its effectiveness in collecting the debts. Receivables turnover ratio is computed by dividing the net value of credit sales by the average accounts receivable during the applicable time period.

Accounts Receivable Turnover Ratio is calculated as:

ARTR = Net Credit Sales / Average Accounts Receivable, where

Average Accounts Receivable = (Beginning Accounts Receivables + Ending Accounts Receivables) / 2

A high ratio implies an efficient credit and a timely collection process, as well as a conservative credit policy, operating mostly on a cash basis. On the other hand, a low ratio implies that the company might have poor collecting process / credit policy / customers. A low ratio often infers that the company has a high amount of cash receivables for collection from its various debtors.

 

Days Sales Outstanding (DSO)

Commonly used by a company as an internal measure to monitor the approximate amount of cash invested in receivables, the Days Sales Outstanding is the average number of days elapsed before the account receivables are collected by the company from the customers. This parameter is expressed in days and is calculated by dividing the amount of accounts receivable during a given period by the total value of credit sales during the same period, and multiplying the resulting ratio by the number of days in the measured time period.

Days Sales Outstanding is calculated as:

DSO = Number of Days * Average Accounts Receivable / Net Credit Sales

and can also be expressed as, DSO = 365 Days / Accounts Receivable Turnover Ratio

A high DSO indicates that a company is taking a longer time to collect the money post sales, resulting in probable cash flow issues. Similarly, a low DSO value indicates better collection processes established by the company. Like with any other ratio, DSO should not be used as a standalone efficiency indicator of a company’s accounts receivable, as inconsistent sales can affect the value of DSO considerably, thereby distorting the cash flow comparison between companies.

 

Accounts Payable Turnover Ratio (APTR)

Also referred to as the Creditor’s Turnover Ratio, the Accounts Payable Turnover Ratio is also a liquidity measure indicating the company’s efficiency in making purchases on credit as a percentage of average accounts payable. Termed as creditor’s velocity, this ratio determines the swiftness at which the company pays its creditors & suppliers.

Accounts Payable Turnover Ratio is calculated as:

APTR = Net Credit Purchases /Average Accounts Payable, where

Average Accounts Payables = (Beginning Accounts Payables + Ending Accounts Payables) / 2

This ratio represents the number of times a company pays its accounts payable during a period. Though there is no defined range, most analysts prefer a range between 8 and 10. Though one might reason that a low ratio should be good for the company, but when the value of this ratio for a company decreases over time and dips below 6 or 5, it is a possible indication of the approaching financial difficulties in meeting the short-term obligations.

 

Days Payable Outstanding (DPO)

Also referred to as Accounts Payable Turnover in Days or Payment Period, Days Payable Outstanding is a measure of the time taken by the company to pay off its invoices from various suppliers, creditors, and other agencies. This parameter relates the accounts payable to the number of days the bills remain unpaid and the cost of goods sold. The ratio is a reflection of the company’s management of cash flows for paying of its account payables in a particular time period.

Days Payable Outstanding is calculated as:

DPO = Number of Days * Average Accounts Payable / Net Credit Purchases

and can also be expressed as, DPO = 365 Days / Accounts Payable Turnover Ratio

A moderately higher DPO is preferable as it indicates the ability of the company to retain the cash for working capital requirement and for other purposes. This is considered good cash management. An extremely high DPO can be a sign of trouble, indicating the business’ inability to make the payments within a reasonable period of time, thereby affecting the future credit terms.

It also depends upon the terms and conditions set by the various suppliers and creditors for each company. A low DPO figure is also not preferable as it implies that a business is paying its vendors earlier than usual, which alternately increases the working capital requirements considerably.

 

Operating Cycle (OC)

A ratio measuring the combined impact of days inventory outstanding (DIO) and days sales outstanding (DSO) is termed as Operating Cycle. Expressed in number of days, it is the time elapsed between a company purchasing (but not paying) raw materials, converting them into finished goods, realizing the inventory sales and collecting the receivables from the customers.

Operating Cycle is calculated as:

OC (Days) = Days Inventory Outstanding + Days Sales Outstanding

A lesser number of operating cycle days implies that the company is able to manufacture, sell and realize the sales (cash) in a short period of time and vice versa. This parameter is a good indicator of the management’s effectiveness and operational efficiency.

 

Cash Conversion Cycle (CCC)

Similar to the operating cycle, and as the name suggests, a measure which adds the days payable outstanding (DPO) to the operating cycle is termed as the Cash Conversion Cycle. Simply defined and expressed in number of days, it is the time taken by the company to purchase raw materials on credit, convert into finished products (inventory), realize cash from sales of the inventory and finally, make the payments to the suppliers.

Cash Conversion Cycle is calculated as:

CCC (Days) = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

CCC as a measure helps in estimating the working capital requirement for business growth on a continuous basis. While DIO provides the quantification of the days taken for inventory to be converted to sales, DSO enumerates the number of days taken to realize the sales to bring in the cash and finally, DPO computes the time taken for payment to the suppliers. Together, they represent a cash-to-cash business cycle or net operating cycle.

Major parameters influencing the CCC are supplier’s payment terms and conditions, company’s credit policy, product portfolio (production vs. trading), inventory policy and other management policies.

 

Working Capital Turnover Ratio (WCTR)

The ratio measuring the effective usage of the company’s working capital in generating sales is termed as the Working Capital Turnover Ratio. This ratio is also referred to as the net sales to working capital ratio, as it indicates the amount of sales generated for every unit of capital spent.

Working Capital Turnover Ratio is calculated as:

WCTR = Net sales / Average Working Capital, where

Average Working Capital = (Beginning Working Capital + Ending Working Capital) / 2

A higher working capital turnover ratio implies that the company is running efficiently and has lesser requirement for additional short term funds. At the same time, too high a ratio is also not preferred, for it implies that the company doesn’t have sufficient short term capital to support the required sales growth. A low ratio implies a higher investment in accounts receivable and inventory for supporting the corresponding sales growth. This may lead to unwarranted bad debts and inventory obsolescence.

 

Fixed Asset Turnover Ratio (FATR)

A ratio indicating the operating leverage of a firm where the net sales are divided by the fixed assets is termed as the Fixed Asset Turnover Ratio. Since the fixed assets comprising plant, property, and equipment account for the largest share of an operational investment in a company, it is imperative to continuously monitor the operating performance, revenue generation and the profitability.

Fixed Asset Turnover Ratio is calculated as:

FATR = Net Sales / Total Fixed Assets, where

Total Fixed Assets = Gross Fixed Assets - Accumulated Depreciation

A high ratio indicates that a business is efficiently generating sales with relatively low fixed assets. It also can imply that the company is outsourcing its manufacturing to reduce investments in fixed assets and thereby, maintaining low in-house production capacity.  At the same time, service oriented companies usually have less of fixed asset build-up as compared to heavy manufacturing sector due to the nature of the business and asset requirement.

 

Total Asset Turnover Ratio (TATR)

Similar to the fixed asset turnover ratio, The Total Asset Turnover Ratio is the measure of the efficiency with which a company is using all of its assets in generating revenue. The only difference between the two ratios is the consideration of either fixed assets or total assets. Along with the working capital ratio, this ratio aids in calculating the efficiency of the available assets. This ratio is also simply referred to as Asset Turnover Ratio.

Total Asset Turnover Ratio is calculated as:

TATR = Net Sales / Total Assets

Higher the asset turnover ratio, the better the company is performing, since higher ratios, imply that the company is generating more revenue through sales per unit value of assets. This ratio is best used to identify the most efficient company in comparison with other firms in that sector.

Most of the financials sourced from the profit and loss account as well as the balance sheet have to be considered on an average basis as the beginning and ending values for a particular time period might differ and distort the computations, leading to an inaccurate understanding of the company.

 

Next Chapter

Leverage Ratios

9 Lessons

Learn how to measure the relative amount of funds raised through equity and debt in detail. Get an insight into the leverage assumed by companies.

Cash Flow Ratios

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Understand the cash generation & utilization by companies with these ratios. Get an insight into how companies manage their cash flows.

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Vicky Rao commented on April 26th, 2019 at 10:59 AM  
Could you please tell me the significance of these ratios in relation to the stock market and trading. Can I trade without calculating the ratios for every company?


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