Friday, May 22, 2009

Financial Ratios, pt 1 - Activity Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

An important component of financial statement analysis is comparisons based on financial ratios. Financial ratios normalize information against size and provide a baseline for comparison with previous years as well as competitors. While comparing two financial ratios may seem meaningless on the surface, comparing two numbers from the past or with a competitor can give information about direction and relative performance.

As with any mathematical ratio, you have a numerator and a denominator. Each financial ratio contains different items in the numerator and denominator and are therefore subject to certain bias or able to describe different aspects. Again, ratios describe interesting relationships when near the value of 1, meaning the numerator is higher than the denominator (for ratios such as coverages etc).

This post will focus on Activity (Operational) financial ratios. These are ratios that measure the efficiency of operations (payables, receivables, inventory, COGS etc).

I had written a post previously about cash flow as the life blood of business in my management consulting blog which deals with the basics of cash flow as well as some queuing theory.

Inventory Ratios
Inventory Turnover = COGS / Average Inv

Inventory turnover describes how many times over an inventory is sold. A high inventory turnover probably indicates that your product moves well, or (in a more negative sense) that you aren't stocking enough and possibly losing out on sales because of stock outs.

Days of Inventory on hand (DOH) =
Number of days in period (usually 365) / Inventory Turnover

DOH is a measure of how long your inventory is sitting idle in storehouses or distribution centers before being sold off (converted) in accounts receivable.

Receivables Ratios
Receivables Turnover = Revenue / Average Receivables

In a parallel train of thought as inventory turn over, receivable turnover is a measure of how much value is sitting in revenue relative to AR. As a collelery to the previous concepts:

Days of Sales Outstanding (DSO) =
Number of days in period (usually 365) / Receivables Turnovers

This describes how long revenues are accrued before being collected on average during the operating year.

Payables Ratios:
Payables Turnover = Purchases from Suppliers / Average Payables

Number of days payable =
Number of days in period (usually 365) / Receivables Turnovers

You'll note the pattern where the you can subsititue either the word 'inventory', 'receivables' or 'payables' using the same formulas to see different relations. In this case, how long it takes for you to pay your suppliers.

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

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