Understanding activity conditions is a very important tool for evaluating a company’s performance. Whether it interprets the financial ratios of your business or evaluates another business, it is important to understand what the activity conditions indicate about a company’s performance. Activity ratios are often called efficiency ratios because they measure how effectively the company manages their assets. Activity relationships can be divided into two categories; turnover ratio and days on hand ratio.
Accounts receivable Accounts = Net sales ÷ Net Receivables
The Group’s receivable turnover measures how many times on average receivables are collected in cash or “turnovers” during the financial year.
Receivable available days = receivable net ÷ Net sales X 365
Available Days Available (ARDOH) is the average number of days required to convert cash receivables. Available account days measure a company’s ability to collect from its customers. This number should be compared with the company’s specified credit terms. By comparing this number with previous years, we can determine if there is an identifiable trend in receivables. An increase in ARDOH could mean that the company has increased credit terms in an effort to increase sales or poor customer management. As a rule of thumb, the upper acceptable limit for a company’s average collection period should be 50% more than the specified conditions. For example, if a company has specified terms of 30 days, the upper limit will be 45 days. Anything longer than 45 days would be cause for concern. If the A / R days available are lower than the stated terms, a company does an excellent job of collecting receivables. If A / R days are available above the specified credit terms, management may need to tighten credit to reduce receivables.
A / R days for the hand ratio is extremely important because it allows us to put a company’s receivable balance from the balance sheet into perspective. If a company has $ 1,000,000 in receivable, then I look good just by looking at the balance sheet, but if we find that A / R days available are well above the company’s stated credit terms, we should ask questions to , how much of these $ 1,000,000 really is collector’s item. In this case, you want to see an aging of accounts receivable to determine how much is likely to be uncollectible.
Inventory = Cost of goods sold ÷ Inventory
Inventory measures how many times average inventory is sold during the year.
Inventory days available = Inventory ÷ Cost of goods sold X 365
Inventory days available measure how many inventory a company has available at a given time. Existing inventories must be compared with previous years to determine the trends affecting inventory and industry averages. Too high of a number could indicate poor inventory management or outdated, unsold or outdated inventor. For example, if a company’s inventory days available are 70 days in Year 1, and it experiences a jump to 90 days in Year 2, the company needs to understand why there was a large jump in inventory days available. There may be many probable causes of the slowdown, such as increased inventory in anticipation of a future shortage, outdated or outdated inventory or poor inventory management. However, if 90 days is the industry average, the jump may not be a major cause for concern. It would be necessary to ask management questions to help understand why storage days on hand changed.
Accounts payable turnover = Cost of goods sold ÷ payments
Payables payable measure how many times, on average, what receivables are collected in cash, the inventory is sold and the debt is paid during the year.
Accounts Payable Days Available = Paying Accounts ÷ Cost of goods sold X 365
Available receivables are the average number of days it takes to pay off debt in cash. This relationship provides insight into a company’s payment pattern. This should be measured against the conditions offered to a company by its suppliers. If the number is higher than the terms offered by suppliers, this may be a cause for concern because suppliers may require cash on delivery. However, a low paid day available increases an increased operating cycle and may entail a need for outside financing.
Another useful tool for evaluating a company’s effectiveness is to calculate the operating cycle.
Operating cycle = A / R days on hand + Inventory days available – A / P days on hand
It is important to understand the relationship these three relationships have in influencing a company’s cash flow. The operating cycle is determined by adding A / R days available and inventory on hand and subtracting A / P days. In short, the operating cycle is the time it takes a company to buy and manufacture goods, pay for the goods, sell the goods and receive cash for goods sold. If a company experiences an increase to A / R days on hand or inventory on hand while A / P days available remain constant, they increase their need for outside financing.
Understanding activity conditions is important to evaluate a company’s performance and effectiveness. It is important to understand how a change in A / R days on hand, inventory days on hand, and A / P days can affect a company’s business cycle. Business owners, managers and investors can all benefit from a solid understanding of business relationships.