Strategic Planning: Measure Your Productivity
The ratios in this section give you a good picture of how productive your company is in using its assets to generate profit. Ratios in this group should be benchmarked against your industry to determine how well you’re performing and where you may find areas of improvement.
Check out these ratios:
Sales to assets: Sales to assets measures how productive your assets are. Look at what you’ve invested in to generate sales and how productive those investments are. You calculate this ratio by dividing gross sales by total assets.
The fictional company, Konas Corp., has gross sales of $778,000 and total assets of $1,120,000, for a sales-to-assets ratio of 0.69. This ratio means that for every dollar the company invests in assets, it generates 69 cents in sales. This may be considered a rather inefficient use of assets.
The management of Konas should launch an investigation: Possible reasons for this low ratio include too much production capacity or old assets. Konas should outsource production and sell assets.
Return on assets (ROA): ROA is another measure of how profitable the company assets are. You calculate ROA by dividing net profit by total assets.
With a net profit of $65,000 and total assets of $1,120,000, Konas’s ROA is 5.8 percent. This percentage means that the company makes almost 6 cents of net profit for every dollar invested in assets.
This ratio should be interpreted in light of the overall risk, and in this instance, the owners of Konas may consider putting the money in a CD and collecting the interest instead of assuming risk with so little return.
Inventory turnover: Inventory turnover measures how many times you sell what’s on your shelves and/or in your warehouse (in the case of a service company, inventory is time, so this ratio isn’t used). Turnover is calculated by dividing cost of goods sold by the cost of the inventory.
Konas has a $423,000 cost of goods sold and $115,000 of inventory, for an inventory turnover ratio of 3.67. Dividing 365 days by 3.67 indicates it takes 99 days for Konas to sell everything in the warehouse. The faster inventory turns, the less it costs and the more efficient operations are. A smart business owner strives to keep inventory turning faster than his or her industry peers.
Receivable turnover: Receivable turnover is the ratio of the number of times that accounts receivable amount is collected throughout the year. A high accounts receivable turnover ratio indicates a tight credit policy. A low or declining accounts receivable turnover ratio indicates a collection problem, part of which may be due to bad debts. To determine the collection time on accounts receivable, divide total sales by accounts receivable.
Konas has gross sales of $778,000 and $178,000 in receivables, for a ratio of 4.3 times a year. After dividing this number into 365 days, it takes Konas 84 days to collect its receivables. This number should be closer to 45 to 60 days.
Accounts payable (A/P) turnover: This ratio shows how many times in one accounting period the company turns over (repays) its accounts payable to creditors.
A higher number indicates either that the business has decided to hold on to its money longer or that it’s having greater difficulty paying. A lower number indicates the company is paying its creditors quickly. To calculate the accounts payable ratio, divide the cost of goods sold by accounts payable.
A/P turnover for Konas is $49,000, with cost of goods sold totaling $423,000, for an A/P ratio of 8.6 times a year. So Konas pays its vendors, suppliers, and others about once every six weeks. Although not bad, wouldn’t you want to be paid in 30 days? Thirty days is the ideal time frame, so Konas should strive to pay its vendors promptly.