AAKASHAYA PATRA SEVEN STAR SMART EDUCATION SERIES PART – 62 : 18.10.2020

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Financial Ratios - Liquidity Ratios

 

Inventory Turnover Ratio: - Inventory turnover ratio is the ratio of Cost of Goods Sold to the Average Inventory. This ratio helps us to analyze how popular are companies products. If the company's products are really popular the inventory turnover ratio would be high otherwise it will be low. 

Inventory Turnover Ratio = Net Sales / Average Inventory 

Inventory Number of Days: - Inventory Number of Days tells us about

How much time (days) the company takes to convert its inventory into cash. 

Inventory Number of Days = 365 / Inventory Turnover Ratio

On one hand, a lower number can indicate that company's products are fast moving and popular which is a good sign but on other hand it can also indicate that the company has a limited production capacity which is not a good sign. This can be due to inability to expand business due to shortage of funds or inability to raise fresh money, shortage of raw materials, etc.

You can come to know about such production capacity related issues only by reading the annual report of the company in details. If you find any such issues then you need to be careful while investing. Hence as a thumb rule, try to check production details whenever you see an impressive Inventory Number of Days figure.

Receivables Turnover Ratio: - The receivables turnover ratio is the ratio of Net Sales to the Average Accounts Receivable.

Accounts Receivable Turnover Ratio = Revenue / Average Receivables

It indicates how many times in a given period of time, the company receives money from its debtors and customers. In other words, it shows a company's effectiveness in extending credit and in collecting debts on that credit. Higher the ratio, better it is as a high number indicates that the company collects cash more frequently.

Days of Sales Outstanding: - Days of Sales Outstanding (DSO) also known as Average Collection Period or the Day Sales in Receivables shows the average cash collection period for the company i.e., the time lag between billing and collection. Both Receivables Turnover and the Days Sales Outstanding indicate the credit policy of the company.

Days Sales Outstanding = 365 / Accounts Receivable Turnover Ratio

Lesser the number of days, the better it is, as quicker the cash collected from the creditors, faster the cash can be used for other activities. A higher number indicates that customers are taking much longer time to pay their bills. This can be due to various reasons like - company offering longer credit to customers, products are sold to customers who are less credit-worthy, lot of competition in market, or customers are dissatisfied with company's products and services. If DSO has been on an increasing trend since last few years then it's a warning sign which needs to be thoroughly investigated before investing in such a company. Never analyze DSO values on quarterly basis as for seasonal business cycle companies DSO value during peak season and off season can be different altogether. Next week we shall try to understand details about remaining Leverage Ratios.

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