[MUSIC PLAYING] This module discusses asset management ratios. These ratios are important to the area of financial statement analysis because they give us an indication of how well assets are being managed internally in an organization and externally as compared to competitive companies or elsewhere in the industry.
Among these asset management ratios are inventory turnover, Days Sales Outstanding, or DSO, fixed asset turnover, and total asset turnover.
Inventory turnover is calculated by taking the cost of goods sold and dividing it by the average inventory. The average inventory is calculated by taking the beginning inventory for the balance sheet period and the ending inventory for the balance sheet period, and dividing it by 2. That gives us an estimate for just what the balance for inventory was at any point during the period.
Here's an example. XYZ Company has a cost of goods sold of 750,000 for the year and the average inventory of 300,000. So what's their inventory turnover? Well, we don't have to calculate the average inventory. We've been given that here as 300,000.
So when we divide that 300,000 into the 750,000, we come up with 2.5 times. That's how this is represented-- as times. We've turned over our inventory 2.5 times. But what does that mean to us?
Well, a low turnover rate may point to over stocking, obsolescence, deficiencies in our product line or in our marketing effort. But in some instances, a low rate may be appropriate, such as when higher inventory levels occur in anticipation of prices rising, or expected market shortages.
Conversely, a high turnover rate may indicate inadequate inventory levels, which could lead to a loss in business because inventory is too low. This often can result in stock shortages.
An item whose inventory is sold or turns over more than once a year has a higher holding cost than one that turns over twice a year or three times a year, or more in that time. Inventory turnover also indicates the briskness of the business.
And the purpose of increasing inventory turns is to reduce inventory for three reasons. Increasing inventory turnover reduces holding cost. And reducing holding cost increases net income and profitability. And items that turn over more quickly increase responsiveness to changes in customer requirements and allowing the replacement of obsolete items.
Day sales outstanding measures the company's average collection period. It's a measure of their accounts receivable and how long it takes a company to collect the money for purchases that have been made from it. This is called days sales outstanding. And it's considered an important tool in managing liquidity.
Day sales outstanding tend to increase as a company becomes less risk averse. And a higher day sales outstanding can also be an indication of an adequate analysis of credit applicants.
Here's how we figure this out. Accounts receivable divided by the average day sales. The day sales is our total sales for the year divided by 365. In this calculation, 365 days is used rather than 360.
Here's an example. LMN company has an accounts receivable of $9,750,000 and total sales of $81,500,000 for the year. So what's their days sales outstanding?
Well, the day sales is $81,500,000 divided by the 365 days, or over $220,000 a day. If our accounts receivable is $9,750,000, our days sales outstanding takes that and divides the $223,287 of day sales. And we have 43.66 days outstanding. This is how it's expressed-- 43.66 days.
So is that good? Well, this means that it is taking us over 30 days to collect $1 in sales. And that's important to the cash conversion cycle of finance.
We should look at our credit policy to see, are we too easily granting credit. Are our collection policies and procedures too slack? We should know exactly what the reason is for our DSO being at 43.66 days.
There are two more higher level asset management ratios-- the fixed and total assets turnover. The fixed assets turnover is calculated by taking total sales and dividing that by the average fixed assets.
This is the ratio of sales to the value of these fixed assets that are on the balance sheets. And it indicates how well the business is using its fixed assets to generate sales. Generally speaking, the higher the ratio, the better, because a higher ratio indicates that the business has less money tied up in fixed assets for each unit of currency of sales revenue.
The total assets turnover is calculated by dividing total sales by the average total assets. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Companies in the retail industry tend to have a very high turnover ratio, mainly due to cutthroat and competitive pricing.
These ratios make up the asset management ratio set.