1.

Introduction

Most businesses exist for the purpose of generating profit and satisfying the consumers
needs. It is the role of the management to ensure such objectives are attained, and hence must
gather sufficient data to inform them how the business is doing. As a manager, you must ask
yourself questions such as whether the companys market share has improved, or whether the
assets are generating enough revenue relative to the amount of money invested, the last of
which can be calculated using efficiency ratios.

To do this, most managers rely on ratio analysis to help them understand trends and financial
statements, which provide crucial information about the companys performance. Ratio
analysis helps them detect strengths and weaknesses of various initiatives and strategies.
The tools can also be used to analyze the companys performance against other firms in the
industry, as well as pinpoint any actions that require corrective measures before it is too late.
For example, a quick acid ratio, which measures whether the company has sufficient liquid
assets to meet its immediate liabilities, can provide a warning before its debts spiral out of
control.

2. What is a ratio?

It is the result of one number or quantity divided by another. Ratios are the simplest
mathematical (statistical) tools that reveal significant relationships hidden in mass of data,
and allow meaningful comparisons. Some ratios are expressed as fractions or decimals, and

some as percentages. Major types of business ratios include (1) Efficiency, (2) Liquidity,
(3) Profitability, and (4) Solvency ratios.

3. What is ratio analysis ?

4. Importance of ratio analysis

When analyzing a company's potential for investment, it is important to examine its financial
performance from every angle. While metrics that measure a company's ability to turn profit
are of paramount importance, the efficiency with which they do so also bears scrutiny. A
2

company may be plenty profitable, but could it do more given the assets it has at its
disposal? Efficiency ratios compare what a company owns to its sales or profit performance
and inform investors about a company's ability to use what it has to generate the most profit
possible for owners and shareholders.

There are numerous efficiency metrics that are easily calculated using the information made
available on a company's financial accounting statements, such as its income statement or
balance sheet. One of the most commonly used metrics is the asset turnover ratio. This ratio
is used to compare a company's net sales to its total average assets. Net sales include all
revenue from a business' primary operations minus any returns or discounts. A business' total
assets are found on the balance sheet and include everything the company owns, including
accounts receivable, real estate, machinery and intangible assets such as goodwill. The asset
turnover ratio reflects the amount of sales revenue generated for every dollar invested in the
company.

The fixed asset turnover ratio is a more refined efficiency metric. This ratio is used to
compare a company's net fixed assets, rather than total assets, to its net sales. Net fixed assets
include those tangible assets that provide operational benefit to the company for an extended
period of time. This metric uses only fixed assets, which are typically comprised of a
company's property, plant and equipment, or PP&E, minus depreciation costs, because these
assets are directly used to produce goods for sale. By comparing sales to the value of these
fixed assets, this efficiency ratio reflects a company's ability to put its long-term resources to
use.

The inventory turnover ratio is especially important for retail businesses. The most accurate
form of this calculation compares the cost of good sold, or COGS, to average inventory. The
result is a ratio that indicates how many times a company sold through its average inventory
during a given period. A high ratio is an indication the company enjoys healthy sales and is

doing a good job of managing its inventory needs. A low ratio can be an indication of several
issues, such as poor advertising, over-production or product obsolescence.

When analyzing these and other efficiency metrics, investors pay special attention to trends in
a company's performance over time. Increasing ratios are a good indication a company is
using its assets, managing production and driving sales effectively. Declining ratios mean
sales are dwindling or the company is overly invested in facilities, equipment, inventory or
other assets that are not generating additional revenue. However, revenue sometimes lags
behind investment. For example, a mediocre fixed asset ratio one year may lead to a much
healthier figure 12 months later as new equipment purchased the year before begins to
contribute to increased production and sales. Similarly, a company may ramp up its inventory
in preparation for a large sales event in the future, making the business look temporarily less
efficient.

Ratios are guides or shortcuts that are useful in evaluating the financial position of a company
and the operations of a company from scientific facts. It helps in comparison of changes in
static data from previous years to current year and with the comparison of other companies as
well. In accounting and financial management ratios are regarded as the real test of earning
capacity, financial soundness and operating efficiency of business concern.

Ratios as a tool of financial analysis provide symptoms with the help of which any analyst is
in a position to diagnose the financial health of the unit. Financial analysis may be compared
with biopsy conducted by the doctor on the patient in order to diagnose the causes of illness
so that treatment may be prescribed to the patient to help him recover.

The following points highlight the Use and Importance of ratio analysis:

Simplifies Accounting Figures: The most significant objective of ratio analysis is that it
simplifies the accounting figures in much easier way by which anyone can be understood it
quite easily even for those who do not know the language of accounting.

Measures Liquidity Position: Liquidity position of a firm is said to be satisfactory if it is able

to meet its current obligation as and when they mature. A firm is said to be capable of
meeting its current obligation only, if it has sufficient liquid funds to pay its short- term
obligations within a period of year. Hence, the liquidity ratios are used for the purpose of
credit analysis by banks and other short-term lenders.

Measures Long-term Solvency: Ratio analysis is equally important in evaluating the longterm solvency of the firm. It is measured by capital structure or leverage ratios. These ratios
are helpful to long-term creditors, security analysts and present and prospective investors, as
they reveal the financial soundness or weakness of the firm.

Measures operational Efficiency: Ratios are useful tools in the hands of management to
evaluate the firms performance over a period of time by comparing the present ratios with
the past ratios. Various activity or turnover ratios measure the operational efficiency of the
firm. These ratios are used in general by the bankers, investors and other suppliers of credit.

Measures Profitability: The management as well as owners of a firm is primarily concerned

with the overall profitability of the firm. Profit and loss account reveals the profit earned or
loss incurring during a period, but fails to convey the capacity of the firm to earn in terms of
money of sales. Profitability ratios help to analysis earning capacity of the firm. Return on
investment, return on capital employed, net profit ratios etc. are the best measures of
profitability.

Facilities Inter-firm and Intra-firm comparisons: Ratio analysis is the basic form of
comparing the efficiency of various firms in the industry and various divisions of a firm.
Absolute figures are not suitable for this purpose, but according ratios are the best tools for
inter firm and inter firm comparison.

Trend Analysis: Trend analysis of ratios reveals whether financial position of the firm is
improving or deteriorating over years because it enables a firm to take the time dimension
into account. With the help of such analysis one can ascertain whether the trend may be
increasing.

Decision Making: Mass of information contained in the financial statements may be

unintelligible a confusing. Ratios help in highlighting the areas deserving attention and
corrective action facilitating decision making.

Financial Forecasting and Planning: Planning and forecasting can be done only by knowing
the past and the present. Ratio help the management in understanding the past and the present
of the unit. These also provide useful idea about the existing strength and weaknesses of the
unit. This knowledge is vital for the management to plan and forecast the future of the unit.

Communication: Ratios have the capability of communicating the desired information to the
relevant persons in a manner easily understood by them to enable them to take stock of the
existing situation.

Co-ordination is Facilitated: Being precise, brief and pointing to the specific areas the ratios
are likely to attract immediate grasping and attention of all concerned and is likely to result in
improved coordination from all quarters of management.

Control is more Effective: System of planning and forecasting establishes budgets, develops
forecast statements and lays down standards. Ratios provide actual basis. Actual can be
compared with the standards. Variances to be computed an analyzed by reasons and
individuals. So it is great help in administering an effective system of control.

Usefulness to the Owners/Shareholders: Existing as well as prospective owners or

shareholders are fundamentally interested in the (a) long-term solvency and (b) profitability
of the unit. Ratio analysis can help them by analyzing and interpreting both the aspects of
their unit.

Usefulness to the Creditors: Creditors may broadly be classified into short-term and long
term. Short-term creditors are trade creditors, bills payables, creditors for expenses etc., they
are interested in analyzing the liquidity of the unit. Long-term creditors are financial
institutions, debenture holders, mortgage creditors etc., they are interested in analyzing the
capacity of the unit to repay periodical interest and repayment of loans on schedule. Ratio
analysis provides, both type of creditors, answers to their questions.

Usefulness to Employees: Employees are interested in fair wages: adequate fringe benefits
and bonus linked with productivity/profitability. Ratio analysis provides them adequate
information regarding efficiency and profitability of the unit. This knowledge helps them to
bargain with the management regarding their demands for improved wages, bonus etc.

Usefulness to the Government: Govt. is interested in the financial information of the units
both at macro as well as micro levels. Individual unit's information regarding production,
sales and profit is required for excise duty, sales tax and income tax purposes. Group
information for the industry is required for formulating national policies and planning. In the
absence of dependable information, Govt. plans and policies may not achieve desired results.

5. Limitations

Ratio analysis can be used to compare information taken from the financial statements to gain
a general understanding of the results, financial position, and cash flows of a business. This
analysis is a useful tool, especially for an outsider such as a credit analyst, lender, or stock
analyst. These people need to create a picture of the financial results and position of a
business just from its financial statements. Although ratio analysis is very important tool to
judge the company's performance, following are the limitations of it.

Different companies operate in different industries each having different

environmental conditions such as regulation, market structure, etc. Such factors are so
significant that a comparison of two companies from different industries might be
misleading.

Financial accounting information is affected by estimates and assumptions.

Accounting standards allow different accounting policies, which impairs
comparability and hence ratio analysis is less useful in such situations.

Ratio analysis explains relationships between past information while users are more
concerned about current and future information.

Ratios are tools of quantitative analysis, which ignore qualitative points of view.

Ratios are generally distorted by inflation.

Ratios give false result, if they are calculated from incorrect accounting data.

Ratios are calculated on the basis of past data. Therefore, they do not
provide complete information for future forecasting.

Ratios may be misleading, if they are based on false or window-dressed accounting

information.

Historical: All of the information used in ratio analysis is derived from actual
historical results. This does not mean that the same results will carry forward into the
future. However, you can use ratio analysis on pro forma information and compare it
to historical results for consistency.

Historical versus current cost: The information on the income statement is stated
in current costs (or close to it), whereas some elements of the balance sheet may be
stated at historical cost (which could vary substantially from current costs). This
disparity can result in unusual ratio results.

Inflation: If the rate of inflation has changed in any of the periods under review, this
can mean that the numbers are not comparable across periods. For example, if the
inflation rate was 100% in one year, sales would appear to have doubled over the
preceding year, when in fact sales did not change at all.

Aggregation: The information in a financial statement line item that you are using for
a ratio analysis may have been aggregated differently in the past, so that running the
ratio analysis on a trend line does not compare the same information through the
entire trend period.

Operational changes: A company may change its underlying operational structure to

such an extent that a ratio calculated several years ago and compared to the same ratio
today would yield a misleading conclusion. For example, if you implemented
a constraint analysis system, this might lead to a reduced investment in fixed assets,
whereas a ratio analysis might conclude that the company is letting its fixed asset base
become too old.

Accounting policies: Different companies may have different policies for recording
the same accounting transaction. This means that comparing the ratio results of
different companies may be like comparing apples and oranges. For example, one
company might use accelerated depreciation while another company uses straight-line
depreciation, or one company records a sale at gross while the other company does so
at net.

Business conditions: You need to place ratio analysis in the context of the general
business environment. For example, 60 days of sales outstanding might be considered
poor in a period of rapidly growing sales, but might be excellent during an economic
contraction when customers are in severe financial condition and unable to pay their
bills.

Interpretation: It can be quite difficult to ascertain the reason for the results of a ratio.
For example, a current ratio of 2:1 might appear to be excellent, until you realize that
the company just sold a large amount of its stock to bolster its cash position. A more
detailed analysis might reveal that the current ratio will only temporarily be at that
level, and will probably decline in the near future.

Company strategy: It can be dangerous to conduct a ratio analysis comparison

between two firms that are pursuing different strategies. For example, one company
10

may be following a low-cost strategy, and so is willing to accept a lower gross

margin in exchange for more market share. Conversely, a company in the same
industry is focusing on a high customer service strategy where its prices are higher
and gross margins are higher, but it will never attain the revenue levels of the first
company.

Point in time: Some ratios extract information from the balance sheet. Be aware that
the information on the balance sheet is only as of the last day of the reporting period.
If there was an unusual spike or decline in the account balance on the last day of the
reporting period, this can impact the outcome of the ratio analysis.

In short, ratio analysis has a variety of limitations that can limit its usefulness. However, as
long as you are aware of these problems and use alternative and supplemental methods to
collect and interpret information, ratio analysis is still useful.

6. Classification

Financial ratios can be classified under the following five groups:

1) Structural
2) Liquidity

11

3) Profitability
4) Turnover
5) Miscellaneous

1. Structural group:

The following are the ratios in structural group:

a) Funded debt to total capitalisation: The term total capitalisation comprises loan term debt,
capital stock and reserves and surplus. The ratio of funded debt to total capitalisation is
computed by dividing funded debt by total capitalisation. It can also be expressed as
percentage of the funded debt to total capitalisation. Long term loans

Total capitalisation (Share capital + Reserves and surplus + long term loans)

b) Debt to equity: Due care must be given to the; computation and interpretation of this ratio.
The definition of debt takes two foremost. One includes the current liabilities while the other
excludes them. Hence the ratio may be calculated under the following two methods:

12

Long term loans + short term credit + Total debt to equity = Current liabilities and
provisions Equity share capital + reserves and surplus (or)

Long-term debt to equity = Long term debt / Equity share capital + Reserves and
surplus

c) Net fixed assets to funded debt: This ratio acts as a supplementary measure to determine
security for the lenders. A ratio of 2:1 would mean that for every rupee of long-term
indebtedness, there is a book value of two rupees of net fixed assets:
d) Funded (long-term) debt to net working capital: The ratio is calculated by dividing the
long-term debt by the amount of the net working capital. It helps in examining creditors
contribution to the liquid assets of the firm.

2. Liquidity group:

It contains current ratio and Acid test ratio.

a) Current ratio: It is computed by dividing current assets by current liabilities. This ratio is
generally an acceptable measure of short-term solvency as it indicates the extent to which he
claims of short term creditors are covered by assets that are likely to be converted into cash in
a period corresponding to the maturity of the claims.

13

Current assets / Current liabilities and provisions + short-term credit against inventory

b) Acid-test ratio: It is also termed as quick ratio. It is determined by dividing quick assets,
i.e., cash, marketable investments and sundry debtors, by current liabilities. This ratio is a
bitterest of financial strength than the current ratio as it gives no consideration to inventory
which may be very a low- moving.

3. Profitability Group:

It has five ratios, and they are calculated as follows:

14

4 Turnover group:

It has four ratios, and they are calculated as follows:

15

5. Miscellaneous group:

It contains four ratio and they are as follows:

16

7. Performance or turnover ratios

Operating Performance Ratios

Each of these ratios have differing inputs and measure different segments
of a company's overall operational performance, but the ratios do give
users insight into the company's performance and management during
the period being measured.

These ratios look at how well a company turns its assets into revenue as
well as how efficiently a company converts its sales into cash. Basically,
these ratios look at how efficiently and effectively a company is using its
resources to generate sales and increase shareholder value. In general,
the better these ratios are, the better it is for shareholders.

In this section, we'll look at the fixed-asset turnover ratio and the
sales/revenue per employee ratio, which look at how well the company
uses its fixed assets and employees to generate sales. We will also look at
the operating cycle measure, which details the company's ability to
convert is inventory into cash.

Operational Performance Ratio Analysis

17

Operational performance ratios measure how different aspects of a companys finances are
performing. The fixed-asset turnover ratio, operating cycle ratio and revenue per employee
ratio each provide a different look into how a company is bringing in revenue, if the business
is spending its money well and how efficiently it is using its assets and resources. Analyzing
these ratios provides deeper insight into the companys finances than simply studying
accounting or other financial records.

Turnover Ratio
It is the percentage of a mutual fund or other investment vehicle's
holdings that have been "turned over" or replaced with other holdings in a
given year. The type of mutual fund, its investment objective and/or the
portfolio manager's investing style will play an important role in
determining its turnover ratio.

For example, a stock index fund will have a low turnover rate, but a bond fund, whether
passively or actively managed, will have high turnover because active trading is an inherent
quality of bond investments. An aggressive small-cap growth stock fund will generally
experience higher turnover than a large-cap value stock fund.

All things being equal, investors should favor low turnover funds. High turnover equates to
higher brokerage transaction fees, which reduce fund returns. Also, the more portfolio
turnover in a fund, the more likely it will generate short-term capital gains, which are taxable
at an investor's ordinary income rate.Turnover ratios for a mutual fund will vary from year to

18

year, but the general range can be assessed by looking at the figure over a few consecutive
years.

Turnover ratios are also known as activity or efficiency ratios. It is the total funds raised by
the company are invested in acquiring various assets for its operations. The assets are
acquired to generate the sales revenue and the position of profit depends upon the value of
sales. Turnover ratios establish the relationship of sales with various assets. Turnover ratios
are expressed in integers or times rather than as a percentage or proportion. The turnover
ratios are mostly computed to measure the efficiency.

8. Types of operational Performance or Turnover ratios

1. Accounts Receivable Turnover

Debtors turnover ratio is also called receivable turnover ratio. This ratio establishes the
relationship between net credit sales and average debtors for the year. Debtors turnover ratio
shows how quickly the credit sales of the company have been converted into cash. This ratio
can be calculated by using the following formula

The accounts receivable turnover is used to measure the efficiency of your companys credit
policies. Too low accounts receivable turnover may show that your company is either finding
it hard to collect debts from customers or that it is granting credit too easily. All factors being
equal, a high accounts turnover is recommended.

19

Debtors Turnover Ratio = Net credit sales/Average account receivable

* The term account receivable includes 'trade debtors and bills receivable'.

Example:

The data of a trading company is given below:

Total sales

$5,500,000

Cash sales

$2,500,000

Accounts receivables opening

$400,000

Accounts receivables closing

$250,000

Notes receivables opening

$150,000

Notes receivables closing

$200,000

How may times (on average) company collects accounts receivables?

Solution:

= $3,000,000* / $500,000**
6 times
On average, the company collects its receivables 6 times a year.
* Credit sales:
$5,500,000 $2,500,000 = $3,000,000
**Average tread receivables:
(400,000+250,000+150,000+200,000)/2 = 500,000

20

2. Inventory Turnover

Inventory turnover ratio is also known as stock turnover ratio. Inventory turnover ratio shows
the relationship between the cost of goods sold and the average inventory. This ratio measures
how frequently the company's inventory turned into sales. This ratio is calculated by using
the following formula.

Inventory turnover can help you determine how well you are managing your companys
inventory levels. If the figure is too low, it means that you are overbuilding or overstocking
the inventory, or that you are having problems pushing sales to consumers. Hence, the higher
the inventory turnover, the better your inventory management policy is. It is measured as
follows;

Inventory Turnover = (Cost of Sales) / (Average Inventory)

In the absence of the cost of goods sold and average stock, the following formula can be used
to calculate inventory turnover ratio.

Inventory turnover ratio = Sales/Closing Inventory = .......... times.

* Cost Of Good Sold = Opening stock+ Purchases+Carriage inward+Direct wages and
expenses- Closing Stock
* Cost Of Good Sold =Sales - Gross profit
* Average stock = (Opening stock + closing stock)/2

21

Example:

Compute the inventory turnover ratio and average selling period from the following data of a
trading company:
Sales

$ 75,000

Gross profit

35,000

Opening inventory

9,000

Closing inventory

7,000

Solution:

$40,000* / $8,000**
5 times

Computation of cost of goods sold and average inventory:

*$75,000 $35,000 = $40,000
**($9,000 + $7,000) / 2
Average selling period is computed by dividing 365 by inventory turnover ratio:
365 days / 5 times
73 days
The company will take 73 days to sell average inventory.

22

3. Accounts Payable Turnover

This ratio measures whether the company has sufficient resources to pay its immediate bills.
If the figure is high, it shows that the company isnt getting healthy payment terms from the
suppliers. It is measured as follows

Accounts Payable Turnover = (Cost of Sales) / (Average Accounts Payable

Example:

P&G trading company has good relations with suppliers and makes all the purchases on
credit. The following data has been extracted from the financial statements of P&G for the
year 2012 and 2011:

Purchases during 2012

$ 220,000

Purchases returns during 2012

20,000

Accounts payable on 31 December, 2011

40,000

Accounts payable on 31 December, 2012

20,000

Notes payable on 31 December, 2011

8,000

Notes payable on 31 December, 2012

12,000

Compute accounts payable turnover ratio (creditors velocity).

23

Solution:

= $200,000* / $40,000**
= 5 times

It means, on average, P&G company pays its creditors 5 times in a year.

* 220,000 20,000
** [(40,000 + 8,000) + (20,000 + 12,000)] / 2

4. Total Assets Turnover

Total assets turnover ratio shows the relationship between total assets and sales. Total assets
turnover ratio indicates how well the firm's total assets are being used to generate its sales.

The total asset turnover shows how efficiently you are using both long-term and short-term
assets. In other words, it measures how efficiently each dollar of your companys assets is
generating sales. An ideal figure is a high total asset turnover. A total assets turnover ratio of
4 means that for each dollar of total assets, the business earns 4 dollars in revenue. It is
computed as shown;

24

Total Assets Turnover ratio = Net Sales/Total Assets

5. Fixed Asset Turnover

This ratio is similar to the total asset turnover, though there are some differences. Fixed
assets, also referred to as property, plant & equipment or non-current assets, refers to assets
that cannot be converted to cash quickly. The higher the figure, the better as it indicates the
amount of money held in the fixed assets is lower per dollar of sales revenue. If the ratio is
low, it indicates that the company has invested too much on fixed assets.

This ratio is a rough measure of the productivity of a company's fixed assets (property, plant
and equipment or PP&E) with respect to generating sales. For most companies, their
investment in fixed assets represents the single largest component of their total assets. This
annual turnover ratio is designed to reflect a company's efficiency in managing these
significant assets. Simply put, the higher the yearly turnover rate, the better.

Fixed Asset Turnover= Net Sales/ (Average Net Fixed Assets), or

Fixed Asset Turnover= (Revenue)/ (Average Fixed Assets)

Example:

X and Y are two independent companies that manufacture office furniture and distribute it to
the sellers as well as customers in various regions of USA . The selected data for both the
companies is give below:

25

Annual sales

75,000 95,000

Sales returns

1,500

Net fixed assets at 1 January 2014

22,500 20,000

Net fixed assets at 31 December 2014

24,000 21,500

1,000

1.

Calculate fixed assets turnover ratio for both the companies.

2.

Can we compare the ratio of company X with that of company Y? If yes, which
company is more efficient in using its fixed assets?

Solution:

(1). Calculation of fixed assets turnover ratio:

X

Net sales (a)

73,500*

94,000*

Average fixed assets (b)

23,250** 20,750**

Fixed assets turnover ratio (a/b)

3.16

4.53

*Net sales:
X: 75,000 1,500
Y: 95,000 1,000
**Average fixed assets:
X: (22,500 + 24,000)/2
Y: (20,000 + 21,500)/2

26

(2). Comparison of two companies:

The ratio of company X can be compared with that of company Y because both the
companies belong to same industry. Generally speaking the comparability of ratios is more
useful when the companies in question are in the same industry.
Company Y generates a sales revenue of $4.53 for each dollar invested in fixed assets where
as company X generates a sales revenue of $3.16 for each dollar invested in fixed assets.
Company Y is therefore more efficient than company X in using the fixed assets.
Significance and interpretation:
Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and a
low ratio means inefficient or under-utilization of fixed assets. The usefulness of this ratio
can be increased by comparing it with the ratio of other companies, industry standards and
past years.

6. Operating Expense Ratio

This ratio measures the cost of operating a property against the income it brings. It helps
compare expenses between analogous properties. If a property has a high operating expense
ratio, it is a signal that corrective measures must be taken to rein the costs. Expenses that can
be used in computing this ratio vary, with the common ones being insurance, taxes,
maintenance and utilities against the gross income. A sum of expenses can also be computed
against the total income, something you will learn how to interpret by studying for this course
on ratios. It is calculated as follows;

Operating Expense Ratio= (Operating Expenses)/ (Total Gross Income or revenue)

27

Example:

The selected data from the records of Good Luck limited is given below:
$
Net sales

200,000

Cost of goods sold

120,000

Administrative expenses

20,000

Selling expense

20,000

Interest charges

10,000

Compute operating ratio for Good Luck limited from the above data.

Solution:

= (160,000* / 200,000) 100

= 80%
The operating profit ratio is 80%. It means 80% of the sales revenue would be used to cover
cost of goods sold and operating expenses of Good Luck limited.
*Computation of operating cost:
Cost of goods sold + Administrative expenses + Selling expenses
= $120,000 + $20,000 + $20,000
= $160,000
28

8. Average Collection Period

Average collection period is also called debt collection period or average age of debtors and
receivables. It indicates how long it takes to realize the credit sales or debtors and
receivables. Average collection period also measures the average credit period enjoyed by the
customers. It indicates the average time lag between credit sales and their conversion into
cash.

Also known as the days sales in accounts receivable, this ratio refers to the average number
of days between when a credit transaction is processed to the date the customer pays for the
product obtained. It helps the company manage its cash flows so that it can meet its current
obligations as they fall due. So an average collection period of 20 days means the business
must wait for 30 days before the debtor can pay up. It is derived as follows;

Average Collection Period = Days in a year/debtors turnover ratio= ......... days.

Or,
Average Collection Period =(Average debtors/Credit Sales)Days in a year= .... days.

Example:

Following data have been extracted from the books of accounts of PQR Ltd.
$
Total sales

200,000
29

Cash sales

77,000

Sales returns

24,000

Accounts receivables (closing)

8,000

Notes receivables (closing)

3,000

Compute average collection period for PQR Ltd.

Solution:

360* /9**
40 days
On average, the PQR limited have to wait for 40 days before the receivables are collected.
*Assumed number of working days in a year.
**Receivables turnover ratio has been calculated as follows:
Net credit sales / Receivables + Notes receivables
99,000 / 8,000 + 3,000
99,000 /11,000 = 9 times
(The denominator consists of closing balances of accounts receivables and notes receivables
because opening balances of these accounts are unknown and the average, therefore, cannot
be worked out)
Computation of credit sales:
Total sales
Less sales returns

$ 200,000
24,000

30


Net sales

176,000

Less cash sales

77,000

Credit sales

99,000

9. Average Payment Period

This ratio calculates the average number of days the business takes to pay its trade debts.
Therefore, an accounts turnover ratio of 25 means the company on averages settles its
accounts payable within 25 days. This ratio is computed as shown below;

Average Payment Period= (365 days in a year) / (Accounts Payable Turnover)

Example:

Metro trading company makes most of its purchases on credit. The extracted data for the year
2012 is given below:
Total purchases

$ 600,000

Cash purchases

150,000

Purchases returns

30,000

Accounts payable at the start of the year

65,000

Accounts payable at the end of the year

40,000

31

Notes payable at the start of the year

20,000

Notes payable at the end of the year

15,000

Calculate average payment period from the above data.

Solution:

When complete information about credit purchases and opening and closing balances of
accounts payable is given, the proper method to compute average payment period is to
compute accounts payable turnover ratio first and then divide the number of working days in
a year by accounts payable turnover ratio.

= $420,000* / $70,000**
= 6 times
Average payment period = 360 days /6 times
60 days

The average payment period of Metro trading company is 60 days. It means, on average, the
company takes 60 days to pay its creditors.
*Computation of net credit purchases:
Total gross purchases
Less purchases returns

$ 600,000
30,000

Net purchases

570,000

32

Less cash purchases

150,000

Net credit purchases

420,000

**Computation of average accounts payable:

[(A/R opening + N/R opening) + (A/R closing + N/R closing)] / 2
[($65,000 + $20,000) + ($40,000 + $15,000)] / 2
[$85,000 + $55,000] / 2
$140,000 /2
$70,000

10. Working capital turnover ratio

Working capital turnover ratio is computed by dividing the cost of goods sold by net working
capital. It represents how many times the working capital has been turned over during the
period.

33

The formula consists of two components cost of goods sold and net working capital. If the
cost of goods sold figure is not available or cannot be computed from the available
information, the total net sales can be used as numerator.

Net working capital is equal to current assets minus current liabilities. This information is
available from the balance sheet. For more explanation consider the following example:

Example:

Exide Company sells batteries that are used in vehicles. The current assets and current
liabilities as on 31 December, 2012 are given below:
Cost of goods sold

$ 300,000

Accounts payable

60,000

Inventory

40,000

Accounts
receivables

50,000

Notes receivables

10,000

Cash

20,000

Compute working capital turnover ratio from the above information.

Solution:

34

= 300,000 / 60,000
= 5 times

The working capital turnover ratio of Exide company is 5. It means the company has turned
over its working capital 5 times in 2012.

9. Conclusion

Efficiency ratios can help you determine whether your business is squeezing every dollar it
can from its operations. It also helps you manage it efficiently, though; it is advised that you
should be aware that there are other factors at play that influence the performance of your
business.

35