Operational Ratios. Meaning + Example + Interpretation
1. DAYS OF RECEIVABLES OR COLLECTION PERIOD
MEANING
What I have in receivables has been sold during the last ‘X’ days but not collected yet. Receivables means that you still have to receive the money, because although you sold it, you did not collect it.
This ratio gives the number of days the company takes, on average, to collect from customers.
Example;
If in 2018 sales were of 40,000€ with daily sales of 40,000/365 days or 109.59€ and 7,000€ in receivables have been sold in the las 80 days = 7,000 / 109.59 per day = 64 days
Another explanation could be the following; the sales of 40,000 have been made in 365 days so the 7,000 that we have in receivables will been sold in ‘X’ days= 7,000 / 40,000 * 365 = 64 days
Formula - Collection period;
= receivables / daily sales
= receivables * 365 / Sales
INTERPRETATION
There are only 2 reasons that explain an increase of receivables:
Sales growth
Worse collection
And, to identify the cause, we calculate the days of collection.
If collection days increase we need to find out the cause and the person or, the department responsible. Some causes of increase in days of collection:
Lack of follow up with customers (customers don’t pay). The responsible of this problem is the administration department.
Worse customers (bad customer). The responsible of this problem is the sales department.
Economic crisis: everybody pays later. The responsible: probably the government, but nobody knows.
Companies always try to keep their collection period very short because it means a small investment in receivables but, it can be possible that the company’s policy, the industry practices, or the quality of the customers, may require a long collection period.
*The Management should be aware that this means a big investment in receivables.
2. DAYS OF INVENTORY AND TURNOVER
MEANING
Inventory is the material you have already in your warehouse and that will be sold in the “x” coming days.
This ratio tells the number of days of sales the company keeps, on average, in the warehouse. The opposite of it is called; Turnover or Rotation.
Example;
If we do have daily COGS of 70€ and our inventory is valued at 1,500 we have goods for “x” days of sales: Inventory period = inventory / daily COGS 1,500 / 70 per day = 21 days of sales
Or, another way to explain it is; with COGS of 25,550€ (70€ * 365) we cover one year of sales; therefore, with 1,300€ we will cover 21 days of sales.
Formula of days of stock;
= Inventory / daily COGS
= inventory * 365 days / COGS
= Inventory * 365 days / sales * (1 – margin)
INTERPRETATION
If stocks increase it may be due to an increase in days of inventory caused by the mismanagement of purchases (purchasing department’s fault).
There could also be other reasons to explain an increase in days of inventory such as;
The possibility that we expect to sell more and therefore, we would invest more in stock although the inventory period remains constant.
Like for receivables, fewer days of stock means less investment in stock which means; lower financial needs and for that reason “just-in-time stock” exists worldwide.
3. DAYS OF PAYABLES OR PAYMENT PERIOD
MEANING
Payables basically means that something has been bought but no paid yet.
This ratio gives the number of days that the company takes to pay its suppliers (on average).
Example;
Taking into account the previous example, if we have 70€ of daily COGS and 3,000 of payables, this 3,000 payables will have been purchased during the last 43 days (3,000 / 70).
Another way of calculating would be the following; the purchases of 25,550 were made during 365 days, so the 3,000 we have in payables will have been purchased during “x” days = 3,000 * 365 days / 25,550 = 43 days
Formula payment period:
= payables / daily purchases
= payables * 365 days / purchases
INTERPRETATION
We use the payment ratio to see whether we are following the payments or delaying them. Usually, if the payment period is long, it means that there is a deterioration of the company’s financial situation (but there are no fix rules, so it’s not always like this).
Longer payment period is not a cause of financial problems but it’s often a consequence and a sign of it. If the company is in financial distressed (mentioned in the Balance Sheet Analysis post) they may feel tempted to take advantage of its suppliers by shortening the payment period to gain extra financing, which may work in a very limited number of cases if the company is powerful but normally, it does not work.
With these three ratios you should have enough information to identify the causes of a company’s financial problems, if any.
The days of cash is also a ratio that is used but it’s becoming, over time, less relevant. Even so, I will explain how it works in case you need it.
4. DAYS OF CASH
MEANING
It means that what the company has in cash it's enough to cover the expenses of the next days.
This ratio gives an idea of how big the cash account is in comparison with the expenses in a daily basis.
Example;
If we take into account that the expenses of the next few days will be; sales of the next few days – net income we can assume that: (*let’s assume that ROS (Return on sales) is 5%)
Daily expenses = daily sales * (1 – ROS*) à 40,000 / 365 days * (1 – 0.050) = 104 reals per day.
“In this case, it’s the same as for days of stocks. We assume that sales and expenses at the beginning of next year will be the same as sales at the end of last year but, we could also calculate the days of cash based on higher future sales and expenses”.
So, if we have 100€ in cash, we have cash for “x” days = cash / daily expenses = 100 / 104 = 0.96 days.
Formulas days of cash;
= cash * 365 days / expenses
= cash * 365 days / sales * (1-ROS)
INTERPRETATION
The bigger the cash, the stronger the company’s financial situation.
More cash = more assets that need to be financed
That’s why companies try to have only the minimum cash required for operations.
With today’s cash-management programs, minimum cash is 0 and days of cash ratios are irrelevant
TIPS
Many companies (especially Commercial ones) use days of cash as a % of Sales and not as a % of Expenses. Both options will drive you into similar results.
In developed financial markets and economies, companies try to have minimum cash, or even 0, in the Balance Sheet because cash is an Assets that has a very small return. In this case, days of cash ratio might be irrelevant but some companies still need to keep a minimum cash for their operations. In this case, days of cash ratio may be relevant.
Information was gathered from "Finance for Manager from Eduardo Martinez Abascal"
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