The ability to sell inventory and collect receivables is critical. In this topic, we discuss three ratios that measure this ability. Inventory Turnover. Companies generally strive to sell their inventory as quickly as possible. The faster inventory sells, the sooner cash comes in.
Inventory turnover, measures the number of times a company sells its average level of inventory during a year. A fast turnover indicates ease in selling inventory; a low turnover indicates difficulty.A value of 6 means that the company's average level of inventory has been sold six times during the year, and that's usually better than a turnover of three times. But too high a value can mean that the business is not keeping enough inventory on hand, which can lead to lost sales if the company can t fill orders. Therefore, a business strives for the most profitable rate of turnover, not necessarily the highest rate. To compute inventory turnover, divide cost of goods sold by the average inventory for the period.
To evaluate inventory turnover, compare the ratio over time.A sharp decline suggests the need for corrective action. Accounts Receivable Turnover. Accounts receivable turnover measures the ability to collect cash from customers. In general, the higher the ratio, the better.
However, a receivable turnover that is too high may indicate that credit is too tight, and that may cause you to lose sales to good customers. To compute accounts receivable turnover, divide net sales by average net accounts receivable. The ratio tells how many times during the year average receivables were turned into cash. Days Sales in Receivables. Businesses must convert accounts receivable to cash.All else being equal, the lower the receivable balance, the better the cash flow.
The days -sales-in-receivables ratio, shows how many days' sales remain in Accounts Receivable. Compute the ratio by a two-step process: 1. Divide net sales by 365 days to figure average sales per day. 2. Divide average net receivables by average sales per day. The ratios discussed so far relate to current assets and current liabilities.
They measure the ability to sell inventory, collect receivables, and pay current bills. Two indicators of the ability to pay total liabilities are the debt ratio and the times-interest-earned ratio.This relationship between total liabilities and total assets is called the debt ratio. Analysts use a second ratio the times-interest earned ratio to relate income to interest expense.
To compute the times-interest-earned ratio, divide income from operations (operating income) by interest expense. This ratio measures the number of times operating income can cover interest expense and is also called the interest-coverage ratio. A high ratio indicates ease in paying interest; a low value suggests difficulty.
