1. Introduction

Most businesses exist for the purpose of generating profit and satisfying the consumers’

needs. It is the role of the management to ensure such objectives are attained, and hence must

gather sufficient data to inform them how the business is doing. As a manager, you must ask

yourself questions such as whether the company’s market share has improved, or whether the

assets are generating enough revenue relative to the amount of money invested, the last of

which can be calculated using efficiency ratios.

To do this, most managers rely on ratio analysis to help them understand trends and financial

statements, which provide crucial information about the company’s performance. Ratio

analysis helps them detect strengths and weaknesses of various initiatives and strategies.

The tools can also be used to analyze the company’s performance against other firms in the

industry, as well as pinpoint any actions that require corrective measures before it is too late.

For example, a quick acid ratio, which measures whether the company has sufficient liquid

assets to meet its immediate liabilities, can provide a warning before its debts spiral out of

control.

2. What is a ratio?

It is the result of one number or quantity divided by another. Ratios are the simplest

mathematical (statistical) tools that reveal significant relationships hidden in mass of data,

and allow meaningful comparisons. Some ratios are expressed as fractions or decimals, and

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some as percentages. Major types of business ratios include (1) Efficiency, (2) Liquidity,

(3) Profitability, and (4) Solvency ratios.

3. What is ratio analysis ?

4. Importance of ratio analysis

When analyzing a company's potential for investment, it is important to examine its financial

performance from every angle. While metrics that measure a company's ability to turn profit

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are of paramount importance, the efficiency with which they do so also bears scrutiny. A

company may be plenty profitable, but could it do more given the assets it has at its

disposal? Efficiency ratios compare what a company owns to its sales or profit performance

and inform investors about a company's ability to use what it has to generate the most profit

possible for owners and shareholders.

There are numerous efficiency metrics that are easily calculated using the information made

available on a company's financial accounting statements, such as its income statement or

balance sheet. One of the most commonly used metrics is the asset turnover ratio. This ratio

is used to compare a company's net sales to its total average assets. Net sales include all

revenue from a business' primary operations minus any returns or discounts. A business' total

assets are found on the balance sheet and include everything the company owns, including

accounts receivable, real estate, machinery and intangible assets such as goodwill. The asset

turnover ratio reflects the amount of sales revenue generated for every dollar invested in the

company.

The fixed asset turnover ratio is a more refined efficiency metric. This ratio is used to

compare a company's net fixed assets, rather than total assets, to its net sales. Net fixed assets

include those tangible assets that provide operational benefit to the company for an extended

period of time. This metric uses only fixed assets, which are typically comprised of a

company's property, plant and equipment, or PP&E, minus depreciation costs, because these

assets are directly used to produce goods for sale. By comparing sales to the value of these

fixed assets, this efficiency ratio reflects a company's ability to put its long-term resources to

use.

The inventory turnover ratio is especially important for retail businesses. The most accurate

form of this calculation compares the cost of good sold, or COGS, to average inventory. The

result is a ratio that indicates how many times a company sold through its average inventory

during a given period. A high ratio is an indication the company enjoys healthy sales and is

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doing a good job of managing its inventory needs. A low ratio can be an indication of several

issues, such as poor advertising, over-production or product obsolescence.

When analyzing these and other efficiency metrics, investors pay special attention to trends in

a company's performance over time. Increasing ratios are a good indication a company is

using its assets, managing production and driving sales effectively. Declining ratios mean

sales are dwindling or the company is overly invested in facilities, equipment, inventory or

other assets that are not generating additional revenue. However, revenue sometimes lags

behind investment. For example, a mediocre fixed asset ratio one year may lead to a much

healthier figure 12 months later as new equipment purchased the year before begins to

contribute to increased production and sales. Similarly, a company may ramp up its inventory

in preparation for a large sales event in the future, making the business look temporarily less

efficient.

Ratios are guides or shortcuts that are useful in evaluating the financial position of a company

and the operations of a company from scientific facts. It helps in comparison of changes in

static data from previous years to current year and with the comparison of other companies as

well. In accounting and financial management ratios are regarded as the real test of earning

capacity, financial soundness and operating efficiency of business concern.

Ratios as a tool of financial analysis provide symptoms with the help of which any analyst is

in a position to diagnose the financial health of the unit. Financial analysis may be compared

with biopsy conducted by the doctor on the patient in order to diagnose the causes of illness

so that treatment may be prescribed to the patient to help him recover.

The following points highlight the Use and Importance of ratio analysis:

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Simplifies Accounting Figures: The most significant objective of ratio analysis is that it

simplifies the accounting figures in much easier way by which anyone can be understood it

quite easily even for those who do not know the language of accounting.

Measures Liquidity Position: Liquidity position of a firm is said to be satisfactory if it is able

to meet its current obligation as and when they mature. A firm is said to be capable of

meeting its current obligation only, if it has sufficient liquid funds to pay its short- term

obligations within a period of year. Hence, the liquidity ratios are used for the purpose of

credit analysis by banks and other short-term lenders.

Measures Long-term Solvency: Ratio analysis is equally important in evaluating the long-

term solvency of the firm. It is measured by capital structure or leverage ratios. These ratios

are helpful to long-term creditors, security analysts and present and prospective investors, as

they reveal the financial soundness or weakness of the firm.

Measures operational Efficiency: Ratios are useful tools in the hands of management to

evaluate the firm’s performance over a period of time by comparing the present ratios with

the past ratios. Various activity or turnover ratios measure the operational efficiency of the

firm. These ratios are used in general by the bankers, investors and other suppliers of credit.

Measures Profitability: The management as well as owners of a firm is primarily concerned

with the overall profitability of the firm. Profit and loss account reveals the profit earned or

loss incurring during a period, but fails to convey the capacity of the firm to earn in terms of

money of sales. Profitability ratios help to analysis earning capacity of the firm. Return on

investment, return on capital employed, net profit ratios etc. are the best measures of

profitability.

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Facilities Inter-firm and Intra-firm comparisons: Ratio analysis is the basic form of

comparing the efficiency of various firms in the industry and various divisions of a firm.

Absolute figures are not suitable for this purpose, but according ratios are the best tools for

inter firm and inter firm comparison.

Trend Analysis: Trend analysis of ratios reveals whether financial position of the firm is

improving or deteriorating over years because it enables a firm to take the time dimension

into account. With the help of such analysis one can ascertain whether the trend may be

increasing.

Decision Making: Mass of information contained in the financial statements may be

unintelligible a confusing. Ratios help in highlighting the areas deserving attention and

corrective action facilitating decision making.

Financial Forecasting and Planning: Planning and forecasting can be done only by knowing

the past and the present. Ratio help the management in understanding the past and the present

of the unit. These also provide useful idea about the existing strength and weaknesses of the

unit. This knowledge is vital for the management to plan and forecast the future of the unit.

Communication: Ratios have the capability of communicating the desired information to the

relevant persons in a manner easily understood by them to enable them to take stock of the

existing situation.

Co-ordination is Facilitated: Being precise, brief and pointing to the specific areas the ratios

are likely to attract immediate grasping and attention of all concerned and is likely to result in

improved coordination from all quarters of management.

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Control is more Effective: System of planning and forecasting establishes budgets, develops

forecast statements and lays down standards. Ratios provide actual basis. Actual can be

compared with the standards. Variances to be computed an analyzed by reasons and

individuals. So it is great help in administering an effective system of control.

Usefulness to the Owners/Shareholders: Existing as well as prospective owners or

shareholders are fundamentally interested in the (a) long-term solvency and (b) profitability

of the unit. Ratio analysis can help them by analyzing and interpreting both the aspects of

their unit.

Usefulness to the Creditors: Creditors may broadly be classified into short-term and long

term. Short-term creditors are trade creditors, bills payables, creditors for expenses etc., they

are interested in analyzing the liquidity of the unit. Long-term creditors are financial

institutions, debenture holders, mortgage creditors etc., they are interested in analyzing the

capacity of the unit to repay periodical interest and repayment of loans on schedule. Ratio

analysis provides, both type of creditors, answers to their questions.

Usefulness to Employees: Employees are interested in fair wages: adequate fringe benefits

and bonus linked with productivity/profitability. Ratio analysis provides them adequate

information regarding efficiency and profitability of the unit. This knowledge helps them to

bargain with the management regarding their demands for improved wages, bonus etc.

Usefulness to the Government: Govt. is interested in the financial information of the units

both at macro as well as micro levels. Individual unit's information regarding production,

sales and profit is required for excise duty, sales tax and income tax purposes. Group

information for the industry is required for formulating national policies and planning. In the

absence of dependable information, Govt. plans and policies may not achieve desired results.

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5. Limitations

Ratio analysis can be used to compare information taken from the financial statements to gain

a general understanding of the results, financial position, and cash flows of a business. This

analysis is a useful tool, especially for an outsider such as a credit analyst, lender, or stock

analyst. These people need to create a picture of the financial results and position of a

business just from its financial statements. Although ratio analysis is very important tool to

judge the company's performance, following are the limitations of it.

Different companies operate in different industries each having different

environmental conditions such as regulation, market structure, etc. Such factors are so

significant that a comparison of two companies from different industries might be

misleading.

Financial accounting information is affected by estimates and assumptions.

Accounting standards allow different accounting policies, which impairs

comparability and hence ratio analysis is less useful in such situations.

Ratio analysis explains relationships between past information while users are more

concerned about current and future information.

Ratios are tools of quantitative analysis, which ignore qualitative points of view.

Ratios are generally distorted by inflation.

Ratios give false result, if they are calculated from incorrect accounting data.

Ratios are calculated on the basis of past data. Therefore, they do not

provide complete information for future forecasting.

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Ratios may be misleading, if they are based on false or window-dressed accounting

information.

Historical : All of the information used in ratio analysis is derived from actual

historical results. This does not mean that the same results will carry forward into the

future. However, you can use ratio analysis on pro forma information and compare it

to historical results for consistency.

Historical versus current cost : The information on the income statement is stated

in current costs (or close to it), whereas some elements of the balance sheet may be

stated at historical cost (which could vary substantially from current costs). This

disparity can result in unusual ratio results.

Inflation : If the rate of inflation has changed in any of the periods under review, this

can mean that the numbers are not comparable across periods. For example, if the

inflation rate was 100% in one year, sales would appear to have doubled over the

preceding year, when in fact sales did not change at all.

Aggregation : The information in a financial statement line item that you are using for

a ratio analysis may have been aggregated differently in the past, so that running the

ratio analysis on a trend line does not compare the same information through the

entire trend period.

Operational changes : A company may change its underlying operational structure to

such an extent that a ratio calculated several years ago and compared to the same ratio

today would yield a misleading conclusion. For example, if you implemented

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a constraint analysis system, this might lead to a reduced investment in fixed assets,

whereas a ratio analysis might conclude that the company is letting its fixed asset base

become too old.

Accounting policies : Different companies may have different policies for recording

the same accounting transaction. This means that comparing the ratio results of

different companies may be like comparing apples and oranges. For example, one

company might use accelerated depreciation while another company uses straight-line

depreciation, or one company records a sale at gross while the other company does so

at net.

Business conditions : You need to place ratio analysis in the context of the general

business environment. For example, 60 days of sales outstanding might be considered

poor in a period of rapidly growing sales, but might be excellent during an economic

contraction when customers are in severe financial condition and unable to pay their

bills.

Interpretation : It can be quite difficult to ascertain the reason for the results of a ratio.

For example, a current ratio of 2:1 might appear to be excellent, until you realize that

the company just sold a large amount of its stock to bolster its cash position. A more

detailed analysis might reveal that the current ratio will only temporarily be at that

level, and will probably decline in the near future.

Company strategy : It can be dangerous to conduct a ratio analysis comparison

between two firms that are pursuing different strategies. For example, one company

may be following a low-cost strategy, and so is willing to accept a lower gross

margin in exchange for more market share. Conversely, a company in the same

industry is focusing on a high customer service strategy where its prices are higher

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and gross margins are higher, but it will never attain the revenue levels of the first

company.

Point in time : Some ratios extract information from the balance sheet. Be aware that

the information on the balance sheet is only as of the last day of the reporting period.

If there was an unusual spike or decline in the account balance on the last day of the

reporting period, this can impact the outcome of the ratio analysis.

In short, ratio analysis has a variety of limitations that can limit its usefulness. However, as

long as you are aware of these problems and use alternative and supplemental methods to

collect and interpret information, ratio analysis is still useful.

6. Classification

Financial ratios can be classified under the following five groups:

1) Structural

2) Liquidity

3) Profitability

4) Turnover

5) Miscellaneous

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1. Structural   group:

The following are the ratios in structural group:

a) Funded debt to total capitalisation: The term ‘total’ capitalisation comprises loan term

debt, capital stock and reserves and surplus. The ratio of funded debt to total capitalisation is

computed by dividing funded debt by total capitalisation. It can also be expressed as

percentage of the funded debt to total capitalisation. Long term loans

Total capitalisation (Share capital + Reserves and surplus + long term loans)

b) Debt to equity: Due care must be given to the; computation and interpretation of this ratio.

The definition of debt takes two foremost. One includes the current liabilities while the other

excludes them. Hence the ratio may be calculated under the following two methods:

Long term loans + short term credit + Total debt to equity = Current liabilities and

provisions Equity share capital + reserves and surplus (or)

Long-term debt to equity = Long – term debt / Equity share capital + Reserves and

surplus

c) Net fixed assets to funded debt: This ratio acts as a supplementary measure to determine

security for the lenders. A ratio of 2:1 would mean that for every rupee of long-term

indebtedness, there is a book value of two rupees of net fixed assets:

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d) Funded (long-term) debt to net working capital: The ratio is calculated by dividing the

long-term debt by the amount of the net working capital. It helps in examining creditors’

contribution to the liquid assets of the firm.

2. Liquidity group:

It contains current ratio and Acid test ratio.

a) Current ratio: It is computed by dividing current assets by current liabilities. This ratio is

generally an acceptable measure of short-term solvency as it indicates the extent to which he

claims of short term creditors are covered by assets that are likely to be converted into cash in

a period corresponding to the maturity of the claims.

Current assets / Current liabilities and provisions + short-term credit against inventory

b) Acid-test ratio: It is also termed as quick ratio. It is determined by dividing “quick assets”,

i.e., cash, marketable investments and sundry debtors, by current liabilities. This ratio is a

bitterest of financial strength than the current ratio as it gives no consideration to inventory

which may be very a low- moving.

3. Profitability Group:

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It has five ratios, and they are calculated as follows:

4 Turnover group:

It has four ratios, and they are calculated as follows:

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5. Miscellaneous group:

It contains four ratio and they are as follows:

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7. Performance or turnover ratios

Operating Performance Ratios

Each of these ratios have differing inputs and measure different segments of a company's

overall operational performance, but the ratios do give users insight into the company's

performance and management during the period being measured.

These ratios look at how well a company turns its assets into revenue as well as how

efficiently a company converts its sales into cash. Basically, these ratios look at how

efficiently and effectively a company is using its resources to generate sales and increase

shareholder value. In general, the better these ratios are, the better it is for shareholders.

In this section, we'll look at the fixed-asset turnover ratio and the sales/revenue per employee

ratio, which look at how well the company uses its fixed assets and employees to generate

sales. We will also look at the operating cycle measure, which details the company's ability to

convert is inventory into cash.

Operational Performance Ratio Analysis

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Operational performance ratios measure how different aspects of a company’s finances are

performing. The fixed-asset turnover ratio, operating cycle ratio and revenue per employee

ratio each provide a different look into how a company is bringing in revenue, if the business

is spending its money well and how efficiently it is using its assets and resources. Analyzing

these ratios provides deeper insight into the company’s finances than simply studying

accounting or other financial records.

Turnover Ratio

It is the percentage of a mutual fund or other investment vehicle's holdings that have been

"turned over" or replaced with other holdings in a given year. The type of mutual fund,

its investment objective and/or the portfolio manager's investing style will play an important

role in determining its turnover ratio.

For example, a stock index fund will have a low turnover rate, but a bond fund, whether

passively or actively managed, will have high turnover because active trading is an inherent

quality of bond investments. An aggressive small-cap growth stock fund will generally

experience higher turnover than a large-cap value stock fund.

All things being equal, investors should favor low turnover funds. High turnover equates to

higher brokerage transaction fees, which reduce fund returns. Also, the more portfolio

turnover in a fund, the more likely it will generate short-term capital gains, which are taxable

at an investor's ordinary income rate.Turnover ratios for a mutual fund will vary from year to

year, but the general range can be assessed by looking at the figure over a few consecutive

years.

Turnover ratios are also known as activity or efficiency ratios. It is the total funds raised by

the company are invested in acquiring various assets for its operations. The assets are

acquired to generate the sales revenue and the position of profit depends upon the value of

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sales. Turnover ratios establish the relationship of sales with various assets. Turnover ratios

are expressed in integers or times rather than as a percentage or proportion. The turnover

ratios are mostly computed to measure the efficiency.

8. Types of operational Performance or Turnover ratios

1.   Accounts Receivable Turnover

Debtors turnover ratio is also called receivable turnover ratio. This ratio establishes the

relationship between net credit sales and average debtors for the year. Debtors turnover ratio

shows how quickly the credit sales of the company have been converted into cash. This ratio

can be calculated by using the following formula

The accounts receivable turnover is used to measure the efficiency of your company’s credit

policies. Too low accounts receivable turnover may show that your company is either finding

it hard to collect debts from customers or that it is granting credit too easily. All factors being

equal, a high accounts turnover is recommended.

Debtors Turnover Ratio = Net credit sales/Average account receivable

* The term account receivable includes 'trade debtors and bills receivable'.

Example:

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The data of a trading company is given below:

Total sales $5,500,000

Cash sales $2,500,000

Accounts receivables – opening $400,000

Accounts receivables – closing $250,000

Notes receivables – opening $150,000

Notes receivables – closing $200,000

How may times (on average) company collects accounts receivables?

Solution:

= $3,000,000* / $500,000**

6 times

On average, the company collects its receivables 6 times a year.

* Credit sales:

$5,500,000 – $2,500,000 = $3,000,000

**Average tread receivables:

(400,000+250,000+150,000+200,000)/2 = 500,000

 2.   Inventory Turnover

Inventory turnover ratio is also known as stock turnover ratio. Inventory turnover ratio shows

the relationship between the cost of goods sold and the average inventory. This ratio

measures how frequently the company's inventory turned into sales. This ratio is calculated

by using the following formula.

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Inventory turnover can help you determine how well you are managing your company’s

inventory levels. If the figure is too low, it means that you are overbuilding or overstocking

the inventory, or that you are having problems pushing sales to consumers. Hence, the higher

the inventory turnover, the better your inventory management policy is. It is measured as

follows;

Inventory Turnover = (Cost of Sales) / (Average Inventory)

In the absence of the cost of goods sold and average stock, the following formula can be used

to calculate inventory turnover ratio.

Inventory turnover ratio = Sales/Closing Inventory = .......... times.

* Cost Of Good Sold = Opening stock+ Purchases+Carriage inward+Direct wages and

expenses- Closing Stock

* Cost Of Good Sold =Sales - Gross profit

* Average stock = (Opening stock + closing stock)/2

Example:

Compute the inventory turnover ratio and average selling period from the following data of a

trading company:

Sales $ 75,000

Gross profit 35,000

Opening inventory 9,000

Closing inventory 7,000

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Solution:

$40,000* / $8,000**

5 times

Computation of cost of goods sold and average inventory:

*$75,000 – $35,000 = $40,000

**($9,000 + $7,000) / 2

Average selling period is computed by dividing 365 by inventory turnover ratio:

365 days / 5 times

73 days

The company will take 73 days to sell average inventory.

3.   Accounts Payable Turnover

This ratio measures whether the company has sufficient resources to pay its immediate bills.

If the figure is high, it shows that the company isn’t getting healthy payment terms from the

suppliers. It is measured as follows

Accounts Payable Turnover = (Cost of Sales) / (Average Accounts Payable

Example:

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P&G trading company has good relations with suppliers and makes all the purchases on

credit.  The following data has been extracted from the financial statements of P&G for the

year 2012 and 2011:

Purchases during 2012 $ 220,000

Purchases returns during 2012 20,000

Accounts payable on 31 December, 2011 40,000

Accounts payable on 31 December, 2012 20,000

Notes payable on 31 December, 2011 8,000

Notes payable on 31 December, 2012 12,000

Compute accounts payable turnover ratio (creditors’ velocity).

Solution:

= $200,000* / $40,000**

= 5 times

It means, on average, P&G company pays its creditors 5 times in a year.

* 220,000 – 20,000

** [(40,000 + 8,000) + (20,000 + 12,000)] / 2

4.   Total Assets Turnover

Total assets turnover ratio shows the relationship between total assets and sales. Total assets

turnover ratio indicates how well the firm's total assets are being used to generate its sales.

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The total asset turnover shows how efficiently you are using both long-term and short-term

assets. In other words, it measures how efficiently each dollar of your company’s assets is

generating sales. An ideal figure is a high total asset turnover. A total assets turnover ratio of

4 means that for each dollar of total assets, the business earns 4 dollars in revenue. It is

computed as shown;

Total Assets Turnover ratio = Net Sales/Total Assets

5.   Fixed Asset Turnover

This ratio is similar to the total asset turnover, though there are some differences. Fixed

assets, also referred to as property, plant & equipment or non-current assets, refers to assets

that cannot be converted to cash quickly. The higher the figure, the better as it indicates the

amount of money held in the fixed assets is lower per dollar of sales revenue. If the ratio is

low, it indicates that the company has invested too much on fixed assets.

This ratio is a rough measure of the productivity of a company's fixed assets (property, plant

and equipment or PP&E) with respect to generating sales. For most companies, their

investment in fixed assets represents the single largest component of their total assets. This

annual turnover ratio is designed to reflect a company's efficiency in managing these

significant assets. Simply put, the higher the yearly turnover rate, the better.

Fixed Asset Turnover= Net Sales/ (Average Net Fixed Assets), or

Fixed Asset Turnover= (Revenue)/ (Average Fixed Assets)

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Example:

X and Y are two independent companies that manufacture office furniture and distribute it to

the sellers as well as customers in various regions of USA . The selected data for both the

companies is give below:

X Y

Annual sales 75,000 95,000

Sales returns 1,500 1,000

Net fixed assets at 1 January 2014 22,500 20,000

Net fixed assets at 31 December 2014  24,000  21,500

1. Calculate fixed assets turnover ratio for both the companies.

2. Can we compare the ratio of company X with that of company Y? If yes, which company is

more efficient in using its fixed assets?

Solution:

(1). Calculation of fixed assets turnover ratio:

X Y

Net sales (a) 73,500* 94,000*

Average fixed assets (b) 23,250** 20,750**

Fixed assets turnover ratio (a/b) 3.16 4.53

*Net sales:

X: 75,000 – 1,500

Y: 95,000 – 1,000

**Average fixed assets:

X: (22,500 + 24,000)/2

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Y: (20,000 + 21,500)/2

(2). Comparison of two companies:

The ratio of company X can be compared with that of company Y because both the

companies belong to same industry. Generally speaking the comparability of ratios is more

useful when the companies in question are in the same industry.

Company Y generates a sales revenue of $4.53 for each dollar invested in fixed assets where

as company X generates a sales revenue of $3.16 for each dollar invested in fixed assets.

Company Y is therefore more efficient than company X in using the fixed assets.

Significance and interpretation:

Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and a

low ratio means inefficient or under-utilization of fixed assets. The usefulness of this ratio

can be increased by comparing it with the ratio of other companies, industry standards and

past years.

6.   Operating Expense Ratio

This ratio measures the cost of operating a property against the income it brings. It helps

compare expenses between analogous properties. If a property has a high operating expense

ratio, it is a signal that corrective measures must be taken to rein the costs. Expenses that can

be used in computing this ratio vary, with the common ones being insurance, taxes,

maintenance and utilities against the gross income. A sum of expenses can also be computed

against the total income, something you will learn how to interpret by studying for this course

on ratios. It is calculated as follows;

Operating Expense Ratio= (Operating Expenses)/ (Total Gross Income or revenue)

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Example:

The selected data from the records of Good Luck limited is given below:

$

Net sales 200,000

Cost of goods sold 120,000

Administrative expenses 20,000

Selling expense 20,000

Interest charges 10,000

Compute operating ratio for Good Luck limited from the above data.

Solution:

= (160,000* / 200,000) × 100

= 80%

The operating profit ratio is 80%. It means 80% of the sales revenue would be used to cover

cost of goods sold and operating expenses of Good Luck limited.

*Computation of operating cost:

Cost of goods sold + Administrative expenses + Selling expenses

= $120,000 + $20,000 + $20,000

= $160,000

8.   Average Collection Period

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Average collection period is also called debt collection period or average age of debtors and

receivables. It indicates how long it takes to realize the credit sales or debtors and

receivables. Average collection period also measures the average credit period enjoyed by the

customers. It indicates the average time lag between credit sales and their conversion into

cash.

Also known as the days’ sales in accounts receivable, this ratio refers to the average number

of days between when a credit transaction is processed to the date the customer pays for the

product obtained. It helps the company manage its cash flows so that it can meet its current

obligations as they fall due. So an average collection period of 20 days means the business

must wait for 30 days before the debtor can pay up. It is derived as follows;

Average Collection Period = Days in a year/debtors turnover ratio= ......... days.

Or,

Average Collection Period =(Average debtors/Credit Sales)Days in a year= .... days.

Example:

Following data have been extracted from the books of accounts of PQR Ltd.

$

Total sales 200,000

Cash sales 77,000

Sales returns 24,000

Accounts receivables – (closing) 8,000

Notes receivables – (closing) 3,000

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Compute average collection period for PQR Ltd.

Solution:

360* /9**

40 days

On average, the PQR limited have to wait for 40 days before the receivables are collected.

*Assumed number of working days in a year.

**Receivables turnover ratio has been calculated as follows:

Net credit sales / Receivables + Notes receivables

99,000 / 8,000 + 3,000

99,000 /11,000 = 9 times

(The denominator consists of closing balances of accounts receivables and notes receivables

because opening balances of these accounts are unknown and the average, therefore, cannot

be worked out)

Computation of credit sales:

Total sales $ 200,000

Less sales returns 24,000

——–

Net sales 176,000

Less cash sales 77,000

——–

Credit sales 99,000

——–

9.   Average Payment Period

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This ratio calculates the average number of days the business takes to pay its trade debts.

Therefore, an accounts turnover ratio of 25 means the company on averages settles its

accounts payable within 25 days. This ratio is computed as shown below;

Average Payment Period= (365 days in a year) / (Accounts Payable Turnover)

Example:

Metro trading company makes most of its purchases on credit. The extracted data for the year

2012 is given below:

Total purchases $ 600,000

Cash purchases 150,000

Purchases returns 30,000

Accounts payable at the start of the year  65,000

Accounts payable at the end of the year 40,000

Notes payable at the start of the year 20,000

Notes payable at the end of the year  15,000

Calculate average payment period from the above data.

Solution:

When complete information about credit purchases and opening and closing balances of

accounts payable is given, the proper method to compute average payment period is to

compute accounts payable turnover ratio first and then divide the number of working days in

a year by accounts payable turnover ratio.

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= $420,000* / $70,000**

= 6 times

Average payment period = 360 days /6 times

60 days

The average payment period of Metro trading company is 60 days. It means, on average, the

company takes 60 days to pay its creditors.

*Computation of net credit purchases:

Total gross purchases $ 600,000

Less purchases returns 30,000

———–

Net purchases 570,000

Less cash purchases 150,000

———–

Net credit purchases 420,000

———–

**Computation of average accounts payable:

[(A/R opening +  N/R opening) + (A/R closing + N/R closing)] / 2

[($65,000 + $20,000) + ($40,000 + $15,000)] / 2

[$85,000 + $55,000] / 2

$140,000 /2

$70,000

10. Working capital turnover ratio

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Working capital turnover ratio is computed by dividing the cost of goods sold by net working

capital. It represents how many times the working capital has been turned over during the

period.

The formula consists of two components – cost of goods sold and net working capital. If the

cost of goods sold figure is not available or cannot be computed from the available

information, the total net sales can be used as numerator.

Net working capital is equal to current assets minus current liabilities. This information is

available from the balance sheet. For more explanation consider the following example:

Example:

Exide Company sells batteries that are used in vehicles. The current assets and current

liabilities as on 31 December, 2012 are given below:

Cost of goods sold $ 300,000

Accounts payable 60,000

Inventory 40,000

Accounts

receivables50,000

Notes receivables 10,000

Cash 20,000

Compute working capital turnover ratio from the above information.

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Solution:

= 300,000 / 60,000

= 5 times

The working capital turnover ratio of Exide company is 5. It means the company has turned

over its working capital 5 times in 2012.

9. Conclusion

Efficiency ratios can help you determine whether your business is squeezing every dollar it

can from its operations. It also helps you manage it efficiently, though; it is advised that you

should be aware that there are other factors at play that influence the performance of your

business.

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