Activity Measures for Accounts Receivable and Inventory Activity - dummies

Activity Measures for Accounts Receivable and Inventory Activity

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Some activity measures quantify the relationship between a company’s assets and sales. Accounting textbooks usually mention a few activity measures. The ones most commonly used are those that measure accounts receivable and inventory activity.

For many companies, accounts receivable and inventory represent the largest account balances in the balance sheet. As a result, performing analysis on these accounts is an important indicator of financial performance.

Ratio analysis that studies activity shows you how well a company is using its assets to make money. This calculation is an expansion of the return on investment (ROI) measurement. The premise is that how well a company uses its assets to generate revenue goes a long way toward telling the tale of its overall profitability.

Presumably, a business that’s effectively and efficiently operated, which activity measures show, will generally be more successful than its less effective and efficient competitors.

Asset turnover analysis shows how well you use assets to generate sales. A higher ratio means more sales per dollar of assets, which is the goal. In other words, efficiently turning over assets indicates a well-run business. The basic formula to calculate asset turnover is this:

Asset turnover = Sales / Average assets

The two most important current assets for the majority of businesses are accounts receivable and inventory. The following sections explain each turnover ratio.

Accounts receivable turnover

Accounts receivable turnover shows the average number of times accounts receivable is turned over during the financial period. In this case, turned over means how often a receivable is posted to the books and then received in cash. Here’s the formula:

Accounts receivable turnover = Net credit sales / Average accounts receivable

Net credit sales represent sales made on credit, less any sales returns and discounts. Average accounts receivable is simply the beginning receivable balance for the period plus the ending receivable balance divided by two.

The sooner a company collects receivables from its customers, the sooner the cash is available to take care of the needs of the business. This turnover rate is a big deal, because the more cash the company brings in from operations, the less it has to borrow for timely payment of its liabilities.

Here’s an example of how to figure accounts receivable turnover: Village Shipping has net credit sales of $35,000 for the year. Accounts receivable (A/R) was $2,500 at January 1 and $1,500 at December 31. The average A/R is ($2,500 + $1,500) / 2 = $2,000. The accounts receivable turnover is $35,000 / $2,000 = 17.5, or 17.5 times.

Another often-used accounts receivable activity measure is the average collection period for accounts receivable, also called days sales outstanding. This measure calculates the average number of days that credit sales remain in accounts receivable — a valuable aid in helping companies develop credit and collection policies.

The average collection period for accounts receivable is figured by dividing accounts receivable as of the last day of the financial period by the average day’s sales (all sales in the financial period divided by 365 days or 366 days in a leap year). This calculation assumes that a business is open each day of the year. It may not be realistic, but it allows the formula to be compared among businesses.

Inventory turnover

Inventory turnover shows how efficiently the company is handling inventory management and replenishment. The less inventory a company keeps on hand, the lower the costs are to store and hold it, thus lowering the cost of inventory having to be financed with debt or by selling equity to investors.

However, keep in mind that running out of inventory hurts business. Low inventory levels can cause lost sales and late deliveries and perhaps strain the company’s relationship with its customers. Also, running low on inventory may cause the company to panic and buy the same inventory for a higher price to get it right now. Too much of that sort of mismanagement can play havoc with the bottom line.

Here’s the formula for inventory turnover:

Inventory turnover = Cost of goods sold / Average inventory value

You calculate average inventory the same way you compute the average for accounts receivable in the prior section. If cost of goods sold are $35,000, and average inventory is $8,500, inventory turnover is $35,000 / $8,500 = 4.12, or 4.12 times.