Asset Management Ratios

A second group of detail ratios is asset management ratios. Asset management ratios measure the ability of assets to generate revenues or earnings. They also compliment our liquidity ratios. We looked at one asset management ratio already; namely Total Asset Turnover when we analyzed Return on Equity. We will now look at five more asset management ratios: Accounts Receivable Turnover, Days in Receivables, Inventory Turnover, Days in Inventory, and Capital Turnover.

Accounts Receivable Turnover

Accounts Receivable Turnover measures the number of times we were able to convert our receivables over into cash. Higher turnover ratios are desirable. Accounts Receivable Turnover is calculated as follows:

Net Sales / Average Accounts Receivable

EXAMPLE - Sales are $ 480,000, the average receivable balance during the year was $ 40,000 and we have a $ 20,000 allowance for sales returns. Accounts Receivable Turnover is ($ 480,000 - $ 20,000) / $ 40,000 or 11.5. We were able to turn our receivables over 11.5 times during the year.

NOTE - We are assuming that all of our sales are credit sales; i.e. we do not have any significant cash sales.

Days in Accounts Receivable

The Number of Days in Accounts Receivable is the average length of time required to collect our receivables. A low number of days is desirable. Days in Accounts Receivable is calculated as follows: 365 or 360 or 300 / Accounts Receivable Turnover

EXAMPLE - If we refer to our previous EXAMPLE and we base our calculation on the full calendar year, we would require 32 days on average to collect our receivables. 365 / 11.5 = 32 days.

Inventory Turnover

Inventory Turnover is similar to accounts receivable turnover. We are measuring how many times did we turn our inventory over during the year. Higher turnover rates are desirable. A high turnover rate implies that management does not hold onto excess inventories and our inventories are highly marketable. Inventory Turnover is calculated as follows: Cost of Sales / Average Inventory

EXAMPLE - Cost of Sales were $ 192,000 and the average inventory balance during the year was $ 120,000. The Inventory Turnover Rate is 1.6 or we were able to turn our inventory over 1.6 times during the year.

Days in Inventory

Days in Inventory is the average number of days we held our inventory before a sale. A low number of inventory days is desirable. A high number of days implies that management is unable to sell existing inventory stocks. Days in Inventory is calculated as follows: 365 or 360 or 300 / Inventory Turnover

EXAMPLE - If we refer back to the previous EXAMPLE and we use the entire calendar year for measuring inventory, then on average we are holding our inventories 228 days before a sale. 365 / 1.6 = 228 days.

Operating Cycle

Now that we have calculated the number of days for receivables and the number of days for inventory, we can estimate our operating cycle.

Operating Cycle = Number of Days in Receivables + Number of Days in Inventory.

In our previous EXAMPLEs, this would be 32 + 228 = 260 days. So on average, it takes us 260 days to generate cash from our current assets. If we look back at our Current Ratio, we found that we had 2.5 times more current assets than current liabilities. We now want to compare our Current Ratio to our Operating Cycle. Our turnover within the Operating Cycle is 365 / 260 or 1.40. This is lower than our Current Ratio of 2.5. This indicates that we have additional assets to cover the turnover of current assets into cash. If our current ratio were below that of the Operating Cycle Turnover Rate, this would imply that we do not have sufficient current assets to cover current liabilities within the Operating Cycle. We may have to borrow short-term to pay our expenses.

Capital Turnover

One final turnover ratio that we can calculate is Capital Turnover. Capital Turnover measures our ability to turn capital over into sales. Remember, we have two sources of capital: Debt and Equity. Capital Turnover is calculated as follows:

Net Sales / Interest Bearing Debt + Shareholders Equity

EXAMPLE - Net Sales are $ 460,000, we have $ 50,000 in Debt and $ 200,000 of Equity. Capital Turnover is $ 460,000 / ($ 50,000 + $ 200,000) = 1.84. For each $ 1.00 of capital invested (both debt and equity), we are able to generate $ 1.84 in sales.