To conduct financial analysis meaningfully, financial statement data needs to be converted into formats conducive to analysis. These formats include, common size formats like common size income statements and balance sheets, graphs like bar and line graphs and ratios like activity ratios, liquidity ratios, profitability ratios, etc. From this post we will begin a series of posts covering the different tools available for conducting financial analysis effectively. In this post we will again go over common size analysis in brief, then cover graphs and then finally see some activity ratio formula. So let’s begin……
Common size analysis
Common size analysis can be performed after converting financial statements to common size formats. In the past posts we have already read about common size income statements, common size balance sheets and common size cash flow statements.
To recap, common size income statement and balance sheet are vertical presentations of the income statement and balance sheet wherein each item in the income statement is expressed as a percentage of sales and each item on the balance sheet is expressed as a percentage of total assets. In a common size cash flow statement, on the other hand, each item is expressed a percentage of revenue.
Common size formats make comparison across time periods and even across peers more meaningful and insightful by standardizing the data presented to a common denominator. Common size formats also make it easy to spot trends.
Graphs are a visual presentation of data. Graphs are used to display performance of certain financial statement elements across time and across peers. Graphs are also useful for spotting trends.
In the past posts we have seen income statement ratios, balance sheet ratios and cash flow statement ratios. In this post we will cover activity ratios. So what are activity ratios? Activity ratios are ratios which are a mix of income statement and balance sheet elements. The same ratio could have an income statement element in the numerator and a balance sheet item in the denominator. Let’s see below some of the activity ratios commonly used to analyze financial statements.
Activity ratios are also known as turnover ratios or operating efficiency ratios or asset utilization ratios. Activity ratios indicate operational efficiency or how well are the assets used. Listed below are the various types of activity ratios.
‘Accounts receivables turnover’ activity ratio
‘Account receivables turnover’ activity ratio formula is given as;
Receivables turnover = Annual credit sales / average accounts receivable
Accounts receivables turnover ratio is one of the activity ratios that measures how well a company manages its sales on credit and how soon it is able to convert its accounts receivables into cash. A low receivables turnover ratio means the firm is not able to convert its credit sales into cash as quickly as it should.
On the other hand a very high receivables turnover ratio may indicate the firm mostly deals on cash basis. While this may be a good thing as such but on the other hand, extending less credit may also mean the firm is losing out to competition. Therefore a receivables turnover ratio closer to the industry average is preferred.
Days of sales outstanding
Days of sales outstanding is calculated as;
Days of sales outstanding = 365 / receivables turnover
DSO is an activity ratio that measures the number of days the firm takes to covert credit sales into cash. A low DSO could indicate the firm’s efficiency in collecting on its credit sales. Alternatively, it could also mean the firm’s credit terms are too stringent, which is causing it to lose out to competition. On the other hand, a high DSO indicates that either the firm’s customers are too slow in paying up or the firm’s credit policy is too lenient. Therefore, a DSO close to the industry average is preferred.
Inventory turnover ratio
‘Inventory turnover’ activity ratio formula is calculated as;
Inventory turnover = cost of goods sold / average inventory
Inventory turnover ratio is another of activity ratios that conveys the efficiency of inventory management. A low inventory turnover ratio could be indicative of slow moving inventory and therefore tied up capital. On the other hand, high inventory turnover ratio could indicate either great efficiency in managing inventory or shortage in inventory, leading to lost sales. Therefore, an inventory turnover ratio near the industry average is preferred.
Days of inventory on hand (DOH)
Days of inventory on hand is calculated as;
DOH = 365/inventory turnover
As with Inventory turnover ratio, a DOH close to the industry average is preferred. A high DOH may indicate slow moving and obsolete inventory while a low DOH may indicate inadequate inventory on hand and lost sales.
Payables turnover ratio
Payables turnover ratio assumes that the firm makes all its purchases on credit. It is an activity ratio that measures the number of times in a year the firm pays off all its creditors. The Payables turnover activity ratio formula is given as;
Payables turnover ratio = annual credit purchases / average trade payables.
Purchases may be calculated as, ending inventory + cost of goods sold – beginning inventory.
A payables turnover ratio close to the industry average is preferred. A high payables turnover ratio could indicate very well the firm is making use of early payment discounts. Alternatively, it may also indicate that the firm is not making full use of credit facilities available. A low ratio could either indicate lenient credit terms or that the firm is having difficulty paying off its debts.
Therefore, it would be wise to consider the payables turnover ratio in conjunction with liquidity ratios. If the liquidity ratios suggest sufficient liquidity and the payables turnover ratio is low, the conclusion to be drawn would be that the firm is enjoying the benefit of lenient credit policies.
Days of payables
Days of payables can be calculated as;
Days of payables = 365 / payables turnover ratio
Days of payables is an activity ratio that indicates the number of days the firm takes to pay its creditors. Low days of payables indicate either timely payment or underuse of credit facilities, while high days of payables indicate either lenient credit policies of the suppliers or difficulty in paying debts.
‘Total asset turnover’ activity ratio formula
Total asset turnover ratio is another of the activity ratios that indicates the firm’s ability to generate revenue by deploying its assets. The ‘total asset turnover’ activity ratio formula is calculated as;
Total asset turnover = Revenue / average total assets.
A high ratio may be indicative of either great efficiency or low asset base. On the other hand, a low ratio may be indicative of too much capital tied up in assets. Therefore, a total asset turnover ratio close to the industry average is preferred.
Fixed Asset turnover ratio
The ‘Fixed asset turnover’ activity ratio formula is given as;
Fixed asset turnover = revenue / average net fixed assets
A ratio closer to the industry average is preferred. A low ratio may indicate too much capital tied up in fixed assets. On the other hand, a high ratio may indicate need to undertake capital expenditures in the near future to support the growing revenues.
Working capital turnover ratio
‘Working capital turnover’ activity ratio formula is given as;
Working capital turnover = revenue / average working capital
A high working capital turnover ratio indicates efficiency; the company is able to generate more revenue per dollar of working capital employed. In cases where working capital is zero or negative (when current liabilities are more than current assets), it is not possible to interpret this ratio.
That’s all in the post ….hope you found it useful and will share it generously……in the next post we move on to liquidity ratios…..further on in the series we will cover important ratios such as liquidity ratios, solvency ratios, profitability ratios and the decomposition of an important profitability ratio i.e. ROE….see you then….
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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