Monday, November 8, 2010

Activity ratios explained for small business owners

Last week we talked about liquidity and leverage ratios so this week we will tackle activity ratios and next week we will dive into profitability ratios.

Activity or Asset Utilization Ratios are used to determine how quickly some accounts are converted into sales or cash.

Accounts Receivable Ratios:

The accounts receivable turnover ratio gives the number of times accounts receivable is collected during the year.

Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable

In general, the higher the accounts receivable turnover, the better, since the business is collecting its money from customers quickly and these funds can then be invested or used again.

The collection period or days sales in receivable is the number of days it takes to collect on receivables.

Average Collection Period = 365/Accounts Receivable Turnover

One cause for an increase in the accounts receivable turnover ratio may be that the business is now selling to financially unstable customers. The owner should review the aging schedule, which lists the accounts receivable according to the length of time they are outstanding to help determine if the credit policy needs revision.

Inventory Ratios:

Inventory turnover = Cost of Goods Sold/Average Inventory

Average Age of Inventory = 365/Inventory Turnover

If a business is holding to much inventory, money that could be used elsewhere is tied up in inventory. In addition, there are high carrying costs for storing the goods as well as the risk of obsolescence. On the other hand, if inventory is too low, the company may lose customers because it has run out of merchandise.

Operating Cycle: The operating cycle is the number of days it takes to convert inventory and accounts receivable to cash. A short operating cycle is desirable.

Operating Cycle = Average Age of Inventory + Average Collection Period

Total Asset Turnover: The total asset turnover ratio is helpful in determining the ability of the business to use its assets effectively to generate revenue.

Total Asset Turnover = Net Sales/Average Total Assets

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