TURNOVER RATIOS

-efficiency in utilization of companys assets

1. Total asset turnover ratio

Ability to generate sales from assets
Formula:
Sales

Average Total Assets

Example: Sally Tech Company is a tech startup company that
manufactures a new tablet computer. Sally is currently looking
for new investors. The investor asks for her financial statements.
Here is what the financial statements reported:
Beginning Assets: 250,000
Ending Assets: 450,000
Sales: 300,000

The Total Asset Turnover Ratio is calculated as:

300,000
250,000 + 450,000
=

0.86 times

= Every dollar in asset, it will only generate 0.86 cents in

sales.
= favorable (using assets more efficiently)
=unfavorable (not using assets more efficiently)

2. FIXED ASSET
TURNOVER RATIO
Fixed asset utilization in sales performance
How well the company generate sales from fixed assets
Measures operating performance/measures companys return on
investment in fixed assets
Formula:
Sales
Average Fixed Assets

Example: ABC Company has average fixed assets of 3,000,000.

Sales over the last 12 months totaled 9,000,000.

. The calculation of ABCs fixed asset turnover ratio is:

= 9,000,000
3,000,000
= 3.0 Turnover per year
Analysis of this ratio might reveal presence of idle assets.
Comparison between the two ratios in a business:
HIGH RATIO

LOW RATIO

-Assets utilized efficiently & large -Assets not fully utilized

sales are generated.
-Selling off fixed asset capacity

-Overinvested in fixed assets

-Needs to issue new products to
revive sales
-has invested in areas that do not
increase the capacity of the

3. Accounts receivable turnover

ratio
Relationship between credit sales and average accounts
receivable balance.
Shows the firms efficiency in credit collection.
Formula:
Credit Sales

Average Accounts Receivable

Example: Bills Medical Supplies is a store that sells medical
supplies. It offers accounts to all customers. At the end of the
year, Bills balance sheet shows 200,000 in accounts receivable,
500,000 of sales. Last years balance sheet showed 100,000 of
accounts receivable.

Calculating Bills Accounts Receivable Turnover Ratio:

=
500,000
(100,000 + 200,000)/2
= 3.33 times
Therefore, Bill collects his receivables 3.33 times a year.
Comparison of the two ratios in a business:
HIGH RATIO

LOW RATIO

-shorter average collection period -too tight credit policy

-efficient credit collection
-conservative policy in credit
collection

-inefficient credit collection

Average collection period

Number of days for the firm to convert receivables to cash
Formula:
360 days

Accounts Receivable Turnover

(Using the previous example)
360 days / 3.33 = 108 days
~~ High accounts receivable turnover corresponds to a
shorter average collection period.

4. Inventory turnover ratio

Ratio of cost of goods sold to average inventory
Measure of the number of times inventory is sold or used in a
time period
Shows the movement of merchandise
Formula:
Cost of Goods Sold

Average Inventory
Example: CDO Company has 460,000 reflected as Cost of
Goods Sold. The average inventory of the company is 86,000.
=
460,000
86,000
= 5.35 times

Days inventory
Also known as days sales of inventory
Formula:
360

Inventory Turnover
(using the previous example)
360 / 5.35 = 67 days
~ It will take 67 days for the entire inventory to be sold.
It depends on the industry. (e.g. manufacturing or
merchandising)

5. OPERATING CYCLE
Cash to cash cycle/Net Operating Cycle/Cash Conversion Cycle
Length of time required to convert cash to finished goods,
receivables, then cash
PRODUCE GOODS
SELL GOODS
RECEIVE CASH
Formula: Days Inventory + Average Collection Period + Days Cash
-Days Cash (represents ability of cash balance to sustain
day-to-day requirements)
-Formula: Ave. Cash Balance * ( 360/ cash operating
expenses)
~~ The length depends on factors

LIQUIDITY RATIO
- reflect the company's capacity to meet
short term obligations.
1. CURRENT RATIO - the most direct
relationship between the company's current
resources and its current obligations.
Current ratio = Current assets
Current liabilities

2. QUICK RATIO - measures the firm's

capacity to cover its short term obligations
using only its more liquid assets.
Quick ratio = Current assets less inventory
Current liabilities

LEVERAGE
RATIOS

LEVERAGE
The use of
variousfinancialinstruments or
borrowed capital, such as margin, to
increase the potential return of an
investment.
The amount of debt used tofinancea
firm's assets. A firm with significantly
more debt than equity is considered
to be highlyleveraged.

LEVERAGE RATIO
one of several financial
measurements that look at
how much capital comes in
the form of debt (loans), or
assesses the ability of a
company to meet financial
obligations.

DEBT TO TOTAL
ASSETS RATIO

indicator of financial
leverage.
tells the percentage of total
assets that were financed by
creditors, liabilities, debt.

Example:

DEBT TO EQUITY
RATIO

a financial and liquidity ratio

comparing a company's total
debt to total equity.
shows the percentage of
company financing that
comes from creditors and
investors.

Example:

USE OF FINANCIAL
RATIOS
4 major categories:
For performance evaluation
For description of the industry
For prediction
For preparation of binding contracts

 Ratios for performance

evaluation
- primary application of financial ratios for all

users of financial statements.

- derives existing or past relationships revealed
by the financial ratios as a basis for future
action.
- needed for evaluation:
*preceding period's financial ratios
*competitor's financial ratios
*industry averages
*budgeted financial ratios
*"benchmark" ratios

 Ratios for description of the

industry
- derives the inherent financial
characteristics of industries and companies
- the primary goal is to understand the
industries better rather than to evaluate their
relative performance.

 Ratios for prediction

2 types of predictions using financial ratios:
1. Ratios for budgeting
-it concerns forecasting for planning
purposes.
Budgeted accounts receivable=Budgeted
sales per day x Budgeted collection period

1.

TOWARD IMPROVED
TECHNIQUES IN RATIO
ANALYSIS
Inflation and Ratio Analysis

- effect of inflation in ratio analysis

a. Gross profit margin will be overstated
b. Net profit margin will be overstated
c. Return on investment is overstated
d. Most turnover ratios are overstated
2. Choice of Standards for Ratio Analysis
a. Should actively consider prevailing economic condition
b. Simultaneously incorporate measures of industry
competitive conditions
c. Should recognize underlying time series patterns
d. Should be unique to the company being analyzed

&

Problems:
3. A trade creditor trying to determine whether to expand sales of
the company
-Analysis will be focused on firms performance, ability to
sell inventories, collect receivables & operate at reasonable
cost.
- Turn-over ratios (Accounts payable turnover ratio,
Accounts receivable turnover ratio)

4. A banker reviewing the companys application for a 90-day

loan to finance an expansion in sales for the Christmas season.
-Leverage Ratios:
a. Debt to Total Assets Ratio (Total Liabilities/Total
Assets)
- % of assets financed by creditors
b. Debt to Equity Ratio (Long Term Debt / Equity)
- use of long-term debt to finance companys
requirements

PROBLEMS:
7. A prospective investor in
the company's preferred
stock.
- dividend payout ratio

- dividend
yield

8. The company's president

who currently holds options
to purchase common stocks
at P25/share at any time till
the end of next year. The
current price of it's
common stock is P23.

- price to
earnings per
share
- asset value per
share

- return on equity