Asset Productivity Ratios for Investment Analysis - dummies

# Asset Productivity Ratios for Investment Analysis

Asset productivity ratios describe how effectively business assets are deployed. These ratios typically look at sales dollars generated per unit of resource. Resources can include accounts receivable, inventory, fixed assets, and occasionally other tangible assets. Similar analyses may also be done not just for financial assets but also for operational assets like square footage, number of employees, and airplane seat miles.

## Receivable turnover

Receivable turnover measures the size of unpaid customer commitments to a company. Specifically, it measures how many times a year this asset is cleared out and replaced by similar obligations from other customers. Rapid turnover, not lingering old debts, is what you want to see. Here’s the formula:

Receivables turnover = sales \$ / accounts receivable \$

Accounts receivable is a resource at a company’s disposal like anything else and must be paid for, essentially by sacrificing cash that otherwise would be available to fund some other part of the business. A company selling direct to consumers with cash sales or bank credit card sales will have lower receivables turnover than an industrial supplier.

## Average collection period (or days’ sales in receivables)

A slightly different way of looking at receivables is to show the average number of days that a given receivable dollar lives on the books. To calculate, divide the receivable turnover ratio (from the preceding section) into 360 to put it on a daily scale:

Average collection period = 360 / receivables turnover

If the collection period is higher than it should be (or growing), watch out. The company may be losing control of its collections or selling to customers with questionable credit.

## Inventory turnover

Inventory turnover works like receivables turnover, only you plug in balance sheet inventory in place of receivables:

Inventory turnover = sales / inventory \$

As with receivable turnover, the higher the number the better. High numbers indicate that raw materials, works in progress, and finished goods are flying onto and off of shelves rapidly. Less dust collects on less stuff in fewer warehouses, and less cash is tied up in inventory.

Deciphering asset productivity ratios means knowing something about the business a company operates in. For example, if a bookseller has a large inventory for its sales, it’s helpful to know that in the bookselling business, shelf inventory is fully returnable to publishers, mitigating inventory risk and providing reader selection — all justifying higher levels of inventory. Know thy industry!

## Fixed asset turnover

This ratio is straightforward:

Fixed asset turnover = sales \$ / fixed asset \$

Obviously, all else being equal, the company that produces the most sales or revenue per dollar of fixed assets wins.

## Total asset turnover

Again, straightforward:

Total asset turnover = –sales \$ / total asset \$

Here we get a bigger picture of asset productivity as measured by the generation of sales. For the first time, intangible assets are included. Again, industry norms form the benchmark. Comparing a railroad to a software company probably doesn’t make sense.