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Accounting For Managers - Ratio Analysis

Analysis Of Turnover (Or) Analysis Of Efficiency - Fixed Assets Turnover Ratio | Current Assets Turnover Ratio | Working Assets Turnover Ratio | Inventory (Or Stock) Turnover Ratio | Debtors Turnover Ratio | Creditors Turnover Ratio

   Posted On :  27.01.2018 10:10 pm

Turnover ratios also referred to as activity ratios are concerned with measuring the efficiency in asset management. Sometimes, these ratios are also called as efficiency ratios or asset utilisation ratios.

The efficiency with which the assets are used would be reflected in the speed and rapidity with which assets are converted into sales. The greater the rate of turnover or conversion, the more efficient the utilisation/management, other things being equal. For this reason such ratios are also designated as turnover ratios. Turnover is the primary mode for measuring the extent of efficient employment of assets by relating the assets to sales. An activity ratio may, therefore, be defined as a test of the relationship between sales (more appropriately with cost of sales) and the various assets of a firm. Depending upon the various types of assets, there are various types of activity ratios. Some of the more widely used turnover ratios are:-

 

ՖՖ   Fixed Assets Turnover Ratio

 

ՖՖ   Current Assets Turnover Ratio

 

ՖՖ   Working Assets Turnover Ratio

 

ՖՖ   Inventory (Or Stock) Turnover Ratio

 

ՖՖ   Debtors Turnover Ratio

 

ՖՖ   Creditors Turnover Ratio

 

 

Fixed Assets Turnover Ratio:

 

 

The fixed assets turnover ratio measures the efficiency with which the firm is utilising its investment in fixed assets, such as land, building, plant and machinery, furniture, etc. It also indicates the adequacy of sales in relation to investment in fixed assets. The fixed assets turnover ratio is sales divided by the net fixed assets (i.e., the depreciated value of fixed assets).

                                                                                                                               Sales

Fixed Assets Turnover Ratio =                ----------------

                                                            Net Fixed Assets

 

The turnover of fixed assets can provide a good indicator for judging the efficiency with which fixed assets are utilised in the firm. A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating operating revenue. A low ratio signifies idle capacity, inefficient utilisation and management of fixed assets.

 

Current Assets Turnover Ratio:

 

 

The current assets turnover ratio ascertains the efficiency with which current assets are used in a business. Professor guthmann observes that “current assets turnover is to give an overall impression of how rapidly the total investment in current assets is being turned”. This ratio is strongly associated with efficient utilisation of costs, receivables and inventory. A higher value of this ratio indicates greater circulation of current assets while a low ratio indicates a stagnation of the flow of current assets. The formula for the computation of current assets turnover ratio is:

                                                                                                          Sales

 

Current Assets Turnover Ratio                                       =           -----------------

 

                                                                                                Current Assets

 

 

Working Capital Turnover Ratio: this ratio shows the number of times working capital is turned-over in a stated period. Working capital turnover ratio reflects the extent to which a business is operating on a small amount of working capital in relation to sales. The ratio is calculated by the following formula:-

 

 

                                                                                                            Sales

 

Working Capital Turnover Ratio                                    =             ----------------------

 

                                                                                                Net Working Capital

 

 

The higher the ratio, the lower is the investment in working capital and greater are the profits. However, a very high turnover of working capital is a sign of over trading and may put the firm into financial difficulties. On the other hand, a low working capital turnover ratio indicates that working capital is not efficiently utilized.

 

 

 

Inventory Turnover Ratio:

 

 

The inventory turnover ratio, also known as stock turnover ratio normally establishes the relationship between cost of goods sold and average inventory. This ratio indicates whether investment in inventory is within proper limit or not. In the words of S.C.Kuchal, “this relationship expresses the frequency with which average level of inventory investment is turned over through operations”. The formula for the computation of this ratio may be expressed thus:

 

                                                                                          Cost Of Goods Sold

 

Inventory Turnover Ratio                                   =              -------------------------

 

                                                                                           Average Inventory

 

 

In general, a high inventory turnover ratio is better than a low ratio. A high ratio implies good inventory management. A very high ratio indicates under-investment in, or very low level of inventory which results in the firm being out of stock and incurring high stock-out cost. A very low inventory turnover ratio is dangerous. It signifies excessive inventory or over-investment in inventory. A very low ratio may be the results of inferior quality goods, over-valuation of closing inventory, stock of unsalable/obsolete goods.

 

Debtors Turnover Ratio And Collection Period:

 

 

One of the major activity ratios is the receivables or debtors turnover ratio. Allied and closely related to this is the average collection period. It shows how quickly receivables or debtors are converted into cash. In other words, the debtors turnover ratio is a test of the liquidity of the debtors of a firm. The liquidity of a firm’s receivables can be examined in two ways:

(i)     debtors/receivables turnover and (ii) average collection period. The debtors turnover shows the relationship between credit sales and debtors of a firm. Thus,

                                          Net Credit Sales

Debtors Turnover Ratio =  ---------------------

                                          Average Debtors

 

 

Net credit sales consists of gross credit sales minus returns if any, from the customers. Average debtors is the simple average of debtors at the beginning and at the end of the year.

 

The second type of ratio measuring the liquidity of a firm’s debtors is the average collection period. This ratio is, in fact, interrelated with and dependent upon, the receivables turnover ratio. It is calculated by dividing the days in a year by the debtors turnover. Thus,

                                                          Days In Year

Average Collection Period =           --------------------

                                                       Debtors Turnover

 

 This ratio indicates the speed with which debtors/accounts receivables are being collected. The higher the turnover ratio and shorter the average collection period, the better the trade credit management and better the liquidity of debtors. On the other hand, low turnover ratio and long collection period reflects that payments by debtors are delayed. In general, short collection period (high turnover ratio) is preferable.

 

Creditors’ Turnover Ratio And Debt Payment Period:

 

 

Creditors’ turnover ratio indicates the speed with which the payments for credit purchases are made to the creditors. This ratio can be computed as follows:-

                                           Average Accounts Payable

Creditors’ Turnover Ratio =  -----------------------------

                                               Net Credit Purchases

 

The term accounts payable include trade creditors and bills payable. A high ratio indicates that creditors are not paid in time while a low ratio gives an idea that the business is not taking full advantage of credit period allowed by the creditors.

 

Sometimes, it is also required to calculate the average payment period or average age of payables or debt period enjoyed to indicate the speed with which payments for credit purchases are made to creditors. It is calculated as:

                                                       Days In A Year

Average Age Of Payables =     --------------------------

                                                Creditors’ Turnover Ratio

 

 

Both the creditors’ turnover ratio and the debt payment period enjoyed ratio indicate about the promptness or otherwise in making payment for credit purchases. A higher creditors’ turnover ratio or lower credit period enjoyed ratio signifies that the creditors are being paid promptly.

 

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