FR - Operation Ratios

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Monday, 23 June 2008 13:52

Ratios are a way to evaluate the performance of your business and identify potential problems. Each ratio informs you about factors such as the earning power, solvency, efficiency, and debt load of your business. They are used to measure the relationship between 2 or more components of the financial statements and have greater meaning when the results are compared to industry standards for businesses of similar size and activity. Operations ratios: measure the effectiveness of internal operations · Accounts receivable turnover · Asset utilization · Average collection period · Average days payable · Days of sale in inventory · Fixed asset utilization · Inventory turnover · Sales per employee Accounts receivable turnover  Calculation: net credit sales / average accounts receivable Measures how liquid accounts receivable is for the year. Average Accounts Receivable is the average of the opening and closing balances for Accounts Receivable. Example: Accounts receivable turnover : 21.53 Indicates the number of times receivables were turned over during the year. This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. A higher turnover rate generally indicates less investment in accounts receivable because customers are paying more quickly Asset utilizationCalculation: net sales / total assets Measures the number of sales dollars earned for each dollar invested in assets. Example: Asset utilization : 0.92 Indicates the dollar amount of sales generated by each $1 of assets. This result can be considered positive or negative, depending on the industry standard for companies of similar size and activity. A low ratio compared to other businesses in the same industry can indicate an over-investment in or inefficient use of assets compared to the competition. The amount of fixed assets should also be considered, particularly if the fixed assets are older and have been recorded at historic costs. A higher ratio value than the industry standard can indicate an efficient use of resources favourable to making profits, or an over-use of production capacity. Over-use of production capacity has the benefit of short-term profits, but can result in the accelerated wear and tear of production equipment, decreasing future profitability when equipment needs to be replaced Average collection period Calculation: (days in the period * average accounts receivable) / net credit sales Measures the average number of days customers take to pay their bills, indicating the effectiveness of credit and collection policies of the business. This ratio also determines if the credit terms are realistic. The Days in the Period is the number of days in the measurement period, normally 365. Average Accounts Receivable is the average of the opening and closing balances of Accounts Receivable for the measurement period. Example: Average collection period : 0.33 day(s) This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. A high value can indicate a collection problem. A low value usually indicates good management of collections but it could also signal an overly tight credit policy limiting sales and profits. Average days payable Calculation: ( days in the period * average accounts payable ) / purchases on credit Measures the average number of days it takes to pay suppliers. The Days in the Period is the number of days in the measurement period, normally 365. Average Accounts Payable is the average of the opening and closing balances of Accounts Payable for the measurement period. Example: Average days payable : 3.62 If the accounts payable period is longer than the collection period, defined by the company's creditors, this may be an indication of ineffective payment procedures or a poor cash position. It may also place creditor relations and the credit rating of the business in jeopardy. If shorter, the firm is not maximizing the benefits of buying on credit, although it will be meeting suppliers' payment terms Days of sales in inventory Calculation: days in the period * average inventory / cost of goods sold Also called Days of Inventory Sales, this ratio indicates the possible number of days of sales with the inventory on hand. It is used to determine whether there is too great an investment in inventory. The Days in the Period is the number of days in the measurement period, normally 365. Average Inventory is the average of the opening and closing balances of inventory for the measurement period. Example: Days of sales in inventory : 0.25 day(s) Tells you the approximate number of days that can be handled with existing inventory. This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. It is important to note that this ratio varies depending on the type of business. For perishable goods, the value should be low; for durable goods, it can be higher Fixed asset utilization Calculation: net sales / average net fixed assets Also called the Sales to Fixed Assets Ratio, it measures the number of sales dollars earned for each dollar of investment in fixed assets. This ratio is normally used in concert with the Asset Utilization Ratio. Average Net Fixed Assets = average of the opening and closing balances of fixed assets. Example: Fixed asset utilization : 1.67 Indicates the number of dollars of net sales are generated by each $100 of fixed assets. This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. A low ratio compared to other companies in the same industry can indicate an over-investment in or inefficient use of fixed assets. A higher ratio than the industry standard can indicate the following: an efficient use of resources, favourable to making profits; an over-use of production capacity; or the reliance on older fixed assets that need to be replaced. Over-use of production capacity has the benefit of short-term profits but can also result in the accelerated wear and tear of production equipment, decreasing future profitability when equipment needs to be replaced Inventory turnover Calculation: cost of goods sold / average inventory Measures the number of times inventory has been turned over (sold and replaced) during the year. It is a good indicator of inventory quality (whether the inventory is obsolete or not), efficient buying practices, and inventory management. This ratio is important because gross profit is earned each time inventory is turned over. Example: Inventory turnover : 16.21 This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. A high turnover rate is an indication of good inventory management as the appropriate amount of inventory is being purchased to meet demand. High turnovers are also a good indicator that the business is less likely to suffer problems carrying inventories of products that may become obsolete (such as fashion items), are seasonal (such as snow shovels), or that deteriorate (such as groceries). It is important to note that this ratio varies according to the type of business. For perishable goods, the turnover rate should be high; for durable goods, it can be lower. A major variance from industry standards may indicate an inventory surplus resulting from a poor purchasing or marketing policy. Sales per employee Calculation: sales for the year / average number of employees Measures the level of sales generated per employee. Average Number of Employees is used as the number of employees can change during the year according to business needs. Sales per employee : 36,497.85 Indicates the approximate dollar value of sales generated per employee for the year. This result can be considered positive or negative, depending on the industry standard for companies of similar size and activity, and the costs attributed to making the sales

Last Updated ( Tuesday, 29 July 2008 06:19 )