24 Asset Management Ratios

Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year.

In accounting, the Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year. The equation for inventory turnover equals the cost of goods sold divided by the average inventory. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.

Inventory Turnover Equation

The formula for inventory turnover:

Inventory turnover = Cost of goods sold/Average inventory

The formula for average inventory:

Average inventory = (Beginning inventory + Ending inventory)/2

The average days to sell the inventory is calculated as follows:

Average days to sell the inventory = 365 days / Inventory turnover ratio

Application in Business

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.

Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of cost of sales. Cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. Cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded. Sales are generally recorded at market value (i.e., the value at which the marketplace paid for the good or service provided by the firm). In the event that the firm had an exceptional year and the market paid a premium for the firm’s goods and services, then the numerator may be an inaccurate measure. However, cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms “cost of sales” and “cost of goods sold” are synonymous.

An item whose inventory is sold (turns over) once a year has a higher holding cost than one that turns over twice, or three times, or more in that time. Stock turnover also indicates the briskness of the business. The purpose of increasing inventory turns is to reduce inventory for three reasons.

• Increasing inventory turns reduces holding cost. The organization spends less money on rent, utilities, insurance, theft, and other costs of maintaining a stock of good to be sold.
• Reducing holding cost increases net income and profitability as long as the revenue from selling the item remains constant.
• Items that turn over more quickly increase responsiveness to changes in customer requirements while allowing the replacement of obsolete items. This is a major concern in fashion industries.

When making comparison between firms, it’s important to take note of the industry, or the comparison will be distorted. Making comparison between a supermarket and a car dealer, will not be appropriate, as a supermarket sells fast moving goods, such as sweets, chocolates, soft drinks, so the stock turnover will be higher. However, a car dealer will have a low turnover due to the item being a slow moving item. As such, only intra-industry comparison will be appropriate.

Days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period.

In accountancy, days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period. It is a financial ratio that illustrates how well a company’s accounts receivables are being managed. The days sales outstanding figure is an index of the relationship between outstanding receivables and credit account sales achieved over a given period.

Typically, days sales outstanding is calculated monthly. The days sales outstanding analysis provides general information about the number of days on average that customers take to pay invoices. Generally speaking, though, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm’s credit policy is too rigorous, which may be hampering sales.

Days sales outstanding is considered an important tool in measuring liquidity. Days sales outstanding tends to increase as a company becomes less risk averse. Higher days sales outstanding can also be an indication of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems, and may result in a decision to increase the creditor company’s bad debt reserve.

A DSO ratio can be expressed as:

• DSO ratio = accounts receivable / average sales per day, or
• DSO ratio = accounts receivable / (annual sales / 365 days)

For purposes of this ratio, a year is considered to have 365 days.

Days sales outstanding can vary from month to month and over the course of a year with a company’s seasonal business cycle. Of interest, when analyzing the performance of a company, is the trend in DSO. If DSO is getting longer, customers are taking longer to pay their bills, which may be a warning that customers are dissatisfied with the company’s product or service, or that sales are being made to customers that are less credit worthy or that sales people have to offer longer payment terms in order to generate sales. Many financial reports will state Receivables Turnover defined as Net Credit Account Sales / Trade Receivables; divide this value into the time period in days to get DSO.

However, days sales outstanding is not the most accurate indication of the efficiency of accounts receivable department. Changes in sales volume influence the outcome of the days sales outstanding calculation. For example, even if the overdue balance stays the same, an increase of sales can result in a lower DSO. A better way to measure the performance of credit and collection function is by looking at the total overdue balance in proportion of the total accounts receivable balance (total AR = Current + Overdue), which is sometimes calculated using the days’ delinquent sales outstanding (DDSO) formula.

Fixed-asset turnover is the ratio of sales to value of fixed assets, indicating how well the business uses fixed assets to generate sales.

Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. This can be compared with current assets, such as cash or bank accounts, which are described as liquid assets. In most cases, only tangible assets are referred to as fixed.

Moreover, a fixed/non-current asset also can be defined as an asset not directly sold to a firm’s consumers/end-users. As an example, a baking firm’s current assets would be its inventory (in this case, flour, yeast, etc.), the value of sales owed to the firm via credit (i.e., debtors or accounts receivable), cash held in the bank, etc. Its non-current assets would be the oven used to bake bread, motor vehicles used to transport deliveries, cash registers used to handle cash payments, etc. Each aforementioned non-current asset is not sold directly to consumers.

These are items of value that the organization has bought and will use for an extended period of time; fixed assets normally include items, such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment ( depreciation allowance) over short-term assets. According to International Accounting Standard (IAS) 16, Fixed Assets are assets which have future economic benefit that is probable to flow into the entity and which have a cost that can be measured reliably.

The primary objective of a business entity is to make a profit and increase the wealth of its owners. In the attainment of this objective, it is required that the management will exercise due care and diligence in applying the basic accounting concept of “Matching Concept.” Matching concept is simply matching the expenses of a period against the revenues of the same period.

The use of assets in the generation of revenue is usually more than a year–that is long term. It is, therefore, obligatory that in order to accurately determine the net income or profit for a period depreciation, it is charged on the total value of asset that contributed to the revenue for the period in consideration and charge against the same revenue of the same period. This is essential in the prudent reporting of the net revenue for the entity in the period.

Fixed-asset Turnover

Fixed-asset turnover is the ratio of sales (on the profit and loss account) to the value of fixed assets (on the balance sheet). It indicates how well the business is using its fixed assets to generate sales.

Fixed asset turnover = Net sales / Average net fixed assets

Generally speaking, the higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.

Total asset turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue.

This is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company.

Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. Companies in the retail industry tend to have a very high turnover ratio due mainly to cut-throat and competitive pricing.

Total assets turnover = Net sales revenue / Average total assets

• “Sales” is the value of “Net Sales” or “Sales” from the company’s income statement “.
• Average Total Assets” is the average of the values of “Total assets” from the company’s balance sheet in the beginning and the end of the fiscal period. It is calculated by adding up the assets at the beginning of the period and the assets at the end of the period, then dividing that number by two.

Net sales

• In bookkeeping, accounting, and finance, Net sales are operating revenues earned by a company for selling its products or rendering its services. Also referred to as revenue, they are reported directly on the income statement as Sales or Net sales.
• In financial ratios that use income statement sales values, “sales” refers to net sales, not gross sales. Sales are the unique transactions that occur in professional selling or during marketing initiatives.

Total assets

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value, and that is held to have positive economic value, is considered an asset. Simply stated, assets represent value of ownership that can be converted into cash (although cash itself is also considered an asset).

The balance sheet of a firm records the monetary value of the assets owned by the firm. It is money and other valuables belonging to an individual or business.

Two major asset classes are tangible assets and intangible assets.

• Tangible assets contain various subclasses, including current assets and fixed assets. Current assets include inventory, while fixed assets include such items as buildings and equipment.
• Intangible assets are non-physical resources and rights that have a value to the firm because they give the firm some kind of advantage in the market place.