Section: 2 Financial Ratio Analysis

Sub Section: 2 Activity Ratios

Accounts Receivable Turnover

This is the number of times accounts receivable, on average, are collected during a year. It also expresses the quality of accounts receivable and the company’s ability to collect them.  Generally a higher turnover ratio is good, but again it might be indicative of overly strict credit policy.



Credit Sales

Average Receivables


Accounts Receivable Collection Period

Also called “Days Sales Outstanding” is the average number of days lapsed for accounts receivable to be converted into cash.  This ratio calculates the relationship between net accounts receivable and average daily sales.



Average Accounts Receivables

Credit Sales / 365


This ratio helps to gauge the liquidity of accounts receivable and the ability of the company to collect them from customers.  It also provides information regarding the credit policy and the quality of accounts receivable. For example, if the average collection period is increasing over time, the company’s credit policy is becoming lenient and is compromising liquidity of accounts receivables. There must be a balance in the credit policy to avoid high bad debt and loss of customers. 


Inventory Turnover

This shows the relationship of how many times inventory was converted into sales.



Cost of Goods Sold

Average Inventory


Generally, a high inventory turnover ratio is indicative of aggressive sales and lower capital tied up in the inventory, which means lower implicit financing cost.  High inventory turnover might also mean under stocking which could lead to delay in customer orders, and ultimately loss of customers.  Higher ratio might also indicate higher sales than expected and a shortage of inventories. On the other hand, low inventory turnover represents weak inventory management system, slow moving or obsolete inventory or excess storage of inventory resulting in high carrying costs.  Similarly, low inventory turnover might stem from further increase in demand, or shortage of raw material.  Analysts should further investigate reasons for abnormally high or low inventory turnover.


One of the most important things to consider is the type of industry in which the company is operating. For example, a company which is involved in selling fresh fruits (perishable item) has a higher turnover ratio than a company selling furniture (non-perishable item).


Inventory Turnover in Days

This shows the ability of a firm to effectively manage inventory.  It indicates the average length of time inventory is held by the firm. Greater inventory turnover is a sign of active business. However, over trading i.e. large volume of business with a small asset base could show the same symptom.



Average Inventory

Cost of Goods Sold / 365


Payable Turnover Period

Measures average time taken by the company to settle the creditors. This is calculated in the same manner as average collection period:



Average Accounts Payable

Cost of Goods Sold / 365


Credits are cost free funds available to the organization and delaying payment is desirable. However, it should not affect the company's image and it should be noted that there could be penalties for late payment.


Total Asset Turnover

Relates total assets to sales. This ratio measures efficiency of the firm in utilizing the assets to generate sales. Efficient management would make use of its assets to generate maximum sales. However, it has to be cautioned that assets are shown at historical cost and thus the ratio could mislead the analyst.




Total Assets


Operating Cycle

The length of time taken from purchases of inputs to collection of receivables resulting from sales is known as operating cycle. This is a useful concept as it gives a basic idea of how long it takes to turn the raw materials into cash. A company which has a shorter operating cycle has the capacity to turn raw materials into sales and then into cash in a relatively shorter period and thus can operate with minimal working capital.



Inventory Turnover in Days + Receivable Turnover in Days


Cash Cycle

The operating cycle starts from the point of purchases of inputs irrespective of the actual payment for such purchases. Cash cycle is the time length between actual outlay of cash for purchases and collection of receivables resulting from sales. This is arrived at by subtracting the time taken to settle the payables from the operating cycle.      



Operating Cycle – Payable Turnover in Days