In our prior articles we have reviewed the accountant's letter, analyzed the balance sheet and income statement, and scrutinized the footnotes. We also discussed balance sheet ratios, such as the current ratio, quick ratio and leverage ratio and income statement ratios, like the cost of goods sold percentage, and net profit percentage.
This final article in the series covers activity ratios. These ratios combine the balance sheet and income statement. They are possibly the most powerful analytical tool for understanding a company financial statement. For example, you can determine if a company's receivables are not being collected, or if inventory is too high, or if cash is going to run out.
There are two basic formats for activity ratios; the turnover ratio; and the average days.
The turnover ratio represents the number of times per year that an asset or liability is used. For instance, an inventory turnover ratio of 6 means that the average inventory item is sold 6 times per year. A payables turnover ratio of 8 means that accounts payables cycle 8 times per year.
The way to calculate a turnover ratio is by dividing the income statement account by the related balance sheet account. The formulas for the most used turnover ratios follows:
Accounts Receivable Turns
Credit Sales / Average Receivable Balance
Cost of Goods Sold / Average Inventory Level
Accounts Payable Turns
Cost of Goods Sold / Average Payables
As always, you should compare your company ratios to industry standards and to historical trends.
After you have computed these three ratios, you may want to continue looking for more opportunities to use this approach. You can divide any income statement item by any balance sheet item. Sometimes this won't yield any useful information, but you might be surprised.
For instance, try dividing maintenance expense by total fixed assets. When you compare the results to the same ratio of other companies, or other time periods, you can determine if maintenance expense is in line.
Closely related to the turnover ratio is the average days calculation. This number represents the average number of days that an asset or liability will last. For instance, a company might have 60 days in accounts receivable, or 45 days in inventory.
The formula for this is to divide the turnover ratio by 360 (or 365, if you are concerned that there are really 365 days in a year).
For example, the inventory turnover of 6 mentioned above computes that there is 60 days in inventory. How many days do you have in accounts receivable?
In order to understand your company, you should calculate your days in receivables, inventory, and payables. These numbers should be compared to industry averages. Also, you should compare these numbers to historical figures, to look for trends. By doing this, you will become a true power reader of financial statements.
What other similar calculations should you make? It depends on you business. As a treasurer of a not-for-profit organization the most important ratio would be days cash available (you would like to see at least 30 days cash on hand). Keep in mind that any balance sheet item can be related to any income statement item by using activity ratios.
This concludes the series of financial statement power user articles. Please try to increase your abilities in financial statement analysis. You will end up making more money on a consistent basis.Return to Library page