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Asset management ratios are important to the area of financial statement analysis because they give 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.
Asset management ratios include:
Inventory turnover ratio is a ratio that measures the number of times inventory is sold or used in a time period. It is calculated by dividing the cost of goods sold by the average inventory. The average inventory is calculated by taking the beginning and ending inventory for the balance sheet period and dividing that in half. This provides an estimate of the balance for the inventory at any point during the period.
IN CONTEXT
XYZ Company has a cost of goods sold of $750,000 for the year and an average inventory of $300,000. What is the inventory turnover?
When we divide the cost of goods sold by the average inventory, we get 2.5. This ratio is expressed as “2.5 times” meaning XYZ Company has turned over its inventory 2.5 times.
A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or in the marketing effort. However, 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 can often result in stock shortages.
Inventory turnover also indicates the briskness of a business. The purpose of increasing inventory turnover is to reduce inventory for the following reasons:
The day sales outstanding ratio measures the company’s average collection period. It is a measure of their accounts receivable and how long it takes a company to collect the money for purchases that have been made. This ratio is considered an important tool in managing liquidity. Day sales outstanding tends to increase as a company becomes less risk averse, and a higher day sales outstanding can also be an indication of inadequate analysis of credit applicants.
The day sales outstanding ratio can be calculated by dividing the accounts receivable by the average day sales. The average day sales is the total sales for the year divided by 365.
IN CONTEXT
LMN Company has an accounts receivable of $9,750,000 and total sales of $81,500,000 for the year. What is the day sales outstanding?
First, we need to calculate the average day sales:
The average day sales is $223,287.67 per day. Now we can calculate the day sales outstanding.
This ratio tells us that LMN Company has 43.66 days outstanding, which means that it is taking over 43 days to collect a dollar in sales. This is important in the cash conversion cycle. The LMN Company should look at the credit policy to see if it is too easily granting credit or if the collection policy procedures are too slack. The company should know exactly why the ratio is at 43.66 days.
The fixed assets turnover ratio is a ratio that measures sales compared to the value of these fixed assets. This ratio indicates how well the business is using its fixed assets to generate sales. Generally, the higher the ratio, the better. A high ratio indicates that the business has less money tied up in fixed assets for each unit of currency of sales revenue.
This ratio is calculated by dividing the total sales by the average fixed assets.
The total assets turnover ratio is a ratio that measures the efficiency of a company’s use of its assets in generating sales revenue. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover.
EXAMPLE
Companies in the retail industry tend to have a very high turnover ratio mainly due to cutthroat competitive pricing.This ratio is calculated by dividing the total sales by the average total assets.
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