Ratio analysis scares many small business owners, but it can be one of the most powerful tools to ensure that your business is on track to its goals. It can also act as an early warning system to let you know that there’s cash flow trouble on the horizon.
Ratios are simply the relationship between two or more numbers. We will be looking at three standard ratios in this article: accounts receivable turnover, accounts payable turnover, and inventory turnover. These three ratios help you determine the health of your working capital (the funds you have available to pay for day-to-day operating expenses).
Accounts Receivable Turnover
This ratio shows how efficient you are at collecting your receivables. The result is expressed in number of days. If your credit policy is net thirty, you would want the ratio to be thirty (or less).
The ratio calculation is: Average Receivables X 365/ Total Annual Credit Sales
So, for example, if your average receivables are $19,500 and your annual credit sales are $153,000, your receivables turnover would be: $19,500 X 365/ 153,000= 46.5 days This tells you that, on average, you are collecting your receivables in 46.5 days. If your credit policy is net thirty, it means that you are not collecting your receivables in an efficient manner. You should examine your receivables and collections policy and tighten up your credit.
It is also useful to look at the progression of this calculation over time. You will know if your new collection policies are working if the ratio days go down over time. However, if they are increasing, alarm bells should ring and more planning is necessary.
Accounts Payable Turnover
This ratio shows you how quickly, on average, you are paying your major suppliers. Like the receivables turnover, it is measured in number of days. If your major vendors give you thirty days to pay, you would want the number to come as close to thirty as possible (or higher, as long as the vendors are not penalizing you for late payment).
The ratio is: Average Payables X 365/ Total Credit Purchases
If, for example, your average payables balance is $9,750 and your average annual credit purchases are $103,000, the ratio would be: $9,750 X 365/ 103,000= 34.6 days This means, on average, you are paying your suppliers in 34.6 days, just over your thirty day terms. If however, you find the ratio calculating at twenty days, this means you are paying your payables before it is necessary to do so. If you are carrying a balance on your company line of credit to do that, then you are most likely not using your resources in the most efficient way.
Let’s say that the receivables and payables turnover examples come from the same company. This company is collecting from its customers in 46.5 days but must pay its suppliers in 34.6 days. There is a financing gap there of almost twelve days. This company would need to make sure that it has sufficient credit to cover this gap, otherwise it will experience a cash flow shortage.
This ratio tells you how quickly, on average, you sell your inventory. Everything else being equal, the smaller the number of days, the better.
The ratio is: Average Inventory on Hand X 365/ Cost of Goods Sold
If your inventory is $36,000 and your average annual cost of goods sold is $97,500, your inventory turnover would be: $36,000 X 365/ 97,500= 134.8 days This means that you are buying inventory and holding it for an average of almost 135 days before selling it. Holding inventory bears a cost to your business in warehousing space needed as well as financing the purchase of the inventory. (For those of you in service industries, the calculation is similar. You would take your work in process- your time spent on projects not yet billed- and multiply it by 365 then divide it by your total sales. The smaller number, the better).
Again, assuming that the ratios belong to the same company, we end up with this timeline:
1) Day 1- Buy inventory for resale
2) Day 34.6- Pay supplier for inventory
3) Day 134.8- Sell inventory item to customer
4) Day 181.3 (46.5 days to collect after sale)- Collect receivable from customer
If this business owner only focused on whether she was making a profit from the sale, she would miss the fact that she needs to be able to finance her purchase for over six months. Many small businesses do not take this into consideration when they start up and they end up being chronically under-capitalized and in a constant cash flow crunch. As you can see, ratios form an important part of your business planning and monitoring. Take out your latest financial statements and work these ratios out for yourself. What are your financial statements trying to tell you?