INTRODUCTION

The term ratio analysis refers to the analysis of the financial statements in conjunction with the
interpretations of financial results of a particular period of operations, derived with the help of
'ratio'. Ratio analysis is used to determine the financial soundness of a business concern.
In this blog post, we will introduce ratio analysis, what it is used for, what are the advantages and
disadvantages of it and its limitations.

MEANING AND DEFINITION OF RATIO ANALYSIS

Ratio analysis is a conceptual technique which dates back to the inception of accounting, as a
concept. Financial analysis as a scientific tool is used to carry out the calculations in the area of
accounting. In order to appraise the valid and existent worth of an enterprise, financial tool comes
handy, regularly. Besides, it also allows the firms to observe the performance spanning across a
long period of time along with the impediments and shortcomings. Financial analysis is an
essential mechanism for a clear interpretation of financial statements. It aids the process of
discovering, the existence of any cross-sectional and time series linkages between various ratios.
Formerly, Security qualified as a major requisite for banks and financial institutions, to consider
and grant loans and advances. However, theres been a complete paradigm shift in the structure.
Currently, lending is based on the evaluation of the actual need of the firms. Financial viability of
a proposal, as a base to grant loans, is now been given precedence over security. Further, an
element of risk is an imperative in every business decision. Credits, run a higher risk, as a part of
any decision making in business and so, Ratio analysis and other quantitative techniques mitigate
the risk to some extent by providing a fair and rational assessment of risks.
Ratio analysis broadly explains the process of computing, acts as a vital tool in determination and
presentation of the relationship of related items and groups of items of the financial statements.
Financial position of a unit is concretely and clearly encapsulated by the means of ratio analysis.
The significance of Ratio Analysis for a holistic Financial Analysis remains unflinchingly
supreme.
Ratio can be used in the form of percentage, Quotient and Rates. In other words, it can be
expressed as a to b; a: b (a is to b) or as a simple fraction, integer and decimal. A ratio is
calculated by dividing one item or figure by another item or figure.
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ANALYSIS OF RATIO
Analysis using ratios can be done in following ways.

Analysis of an individual (or) Single Ratio

Analysis of referring to a Group of Ratio

Analysis of ratios by Trend

Analysis by inter-firm comparison

ADVANTAGES OF RATIO ANALYSIS

In order to establish the relationship between two accounting figures, application of Ratio
Analysis is necessary. Application of the same provides the significant information to the
management or users who can analyse the business situation. It also facilitates meaningful and
productive monitoring of the annual performance of the firm. Illustrated below are the advantages
of ratio analysis:

It facilitates the accounting information to be summarized and simplified in a concise and

concrete form which is comprehensible to the user.

It depicts the inter-relationship between the facts and figures of various segments of
business which are instrumental in taking important financial decisions.

Ratio analysis clears all the impediments and inefficiencies related to performance of the
firm/individual.

It equips the management with the requisite information enables them to take prompt
business -decisions.

It helps the management in effectively discharging its functions/operations such as

planning, organizing, controlling, directing and forecasting.

Ratio analysis provides a detailed account of profitable and unprofitable activities. Thus,
the management is able to concentrate on unprofitable activities and consider the necessary steps
to overcome the existential shortcomings.

Ratio analysis is used as a benchmark for effective control of performance of business

activities.

Ratios are an effectual means of communication and informing about financial soundness
made by the business concern to the proprietors, investors, creditors and other parties.

Ratio analysis is an effective tool which is used for measuring the operating results of the
enterprises.

It facilitates control over the operation as well as resources of the business.

Ratio analysis provides all assistance to the management to discharge responsibilities.

Ratio analysis aids in accurate determination of the performance of liquidity, profitability

and solvency position of the business concern.

LIMITATIONS OF RATIO ANALYSIS

Various environmental conditions such as regulation, market structures etc. vary for
different companies, operating in different industries. Significance of such factors is extremely
high. This variation may lead to a difference or an element of discrepancy, while comparing the
two companies from diverse industries.

Financial accounting information is impacted and often subject to change, by estimates

and assumptions. Accounting standards allow scope for incorporating different accounting
policies, which impairs comparability and hence functionality of ratio analysis is less in such
situations.

Ratio analysis explicates association between past information while current and future
information is of more relevance and application to the users.

TYPES OF ACCOUNTING RATIOS

A number of possible ratios can be used to analyze financial statements, including the following
most commonly used accounting ratios:

LIQUIDITY RATIOS show how liquid the organization is. An organization is liquid if it can
pay its bills on time. Three liquidity ratios are:
1. Current Ratio is one of the most commonly used ratios. It is equal to Current Assets
divided by Current Liabilities.
2. Quick Ratio = Quick Assets / Current Liabilities
3. where Quick Assets = Cash + Short Term Securities + Accounts Receivable
4. Net Working Capital Ratio = (Current Assets - Current Liabilities) / Total Assets

PROFITABILITY RATIOS show an organization's returns on investments. Profitability

ratios include:
1. Profit Margin = Net Income / Revenue
2. Return on Assets = Net Income / Average Total Assets
3. Average Total Assets equals ending plus beginning Total Assets divided by two
4. Return on Equity = Net Income / Average Stockholders' Equity
5. Average Stockholders' Equity equals beginning plus ending stockholders' equity divided
by two. Return on Common Equity is a similar ratio but uses average common
stockholders' equity.

CAPITAL STRUCTURE RATIOS show how an organization has financed the purchase
of assets and include:

1. Debt to Equity Ratio = Total Liabilities / Total Stockholders' Equity

2. Interest Coverage Ratio = Income Before Income Taxes and Interest Expense)
3. Debt to Asset Ratio = Total Liabilities / Total Assets

MARKET VALUE RATIOS show the value created for shareholders and include:
1. Price Earnings (P/E) ratio = Price per share of common stock / Earnings per share
2. Dividend yield = Per share dividend / Per share price
3. Dividend payout ratio = Common Stock Cash Dividends / Net Income
4. Market to Book Ratio = Common share market value / Common share book value

ACTIVITY ANALYSIS RATIOS show how efficient the organization has been in using
its assets to generate sales and include:
1. Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
2. Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable
3. Assets Turnover Ratio = Sales / Average Total Assets

PERFORMANCE RATIO
The word Performance is derived from the word parfourmen, which means to do, to carry
out or to render. It refers the act of performing; execution, accomplishment, fulfilment, etc. In
border sense, performance refers to the accomplishment of a given task measured against preset
standards of accuracy, completeness, cost, and speed. In other words, it refers to the degree to
which an achievement is being or has been accomplished. In the words of Frich Kohlar The
performance is a general term applied to a part or to all the conducts of activities of an
organization over a period of time often with reference to past or projected cost efficiency,
management responsibility or accountability or the like. Thus, not just the presentation, but the
quality of results achieved refers to the performance. Performance is used to indicate firms
success, conditions, and compliance. Financial performance refers to the act of performing
financial activity. In broader sense, financial performance refers to the degree to which financial
objectives being or has been accomplished. It is the process of measuring the results of a firm's
policies and operations in monetary terms. It is used to measure firm's overall financial health
over a given period of time and can also be used to compare similar firms across the same
industry or to compare industries or sectors in aggregation.

TYPES OF PERFORMANCE RATIO

There are several types of performance ratios are given below:
1)
2)
3)
4)
5)
6)
7)
8)

Total Asset Turnover Ratio

Fixed Assets Turnover Ratio
Capital Turnover Ratio
Current Assets Turnover Ratio
Working Capital Turnover Ratio
Inventory Turnover Ratio
Debtors Turnover Ratio
Receivables ( Debtors) Ratio
9) Payables Turnover Ratio

1) TOTAL ASSET TURNOVER RATIO:

2) Asset turnover ratio is the ratio of the value of a companys sales or revenues generated
relative to the value of its assets. The Asset Turnover ratio can often be used as
an indicator of the efficiency with which a company is deploying its assets in generating
revenue.

This ratio measures the efficiency with whixh the firm uses its total assets. This ratio is
computes as:

3) Formula:
4) Total Turnover Ratio =

Sales / Cost of Goods Sold

5)
6)

Total Assets
Generally speaking, the higher the asset turnover ratio, the better the company

is performing, since higher ratios imply that the company is generating more revenue per
dollar of assets. Yet, this ratio can vary widely from one industry to the next. As such,
considering

the

asset

turnover

ratios

of

an energy company

and

a telecommunications company will not make for an accurate comparison. Comparisons are
only meaningful when they are made for different companies within the same sector.

7) BREAKING DOWN 'Asset Turnover Ratio'

8) Asset

turnover

is

typically

calculated

over

an annual basis

using

either

the fiscal or calendar year. The total assets number used in the denominator can be calculated
by taking the average of assets held by a company at the beginning of the year and at the
years end.

9) For example, suppose company X has an asset base of $400 million at the beginning of a
given year and $500 million at the end of the same year, and suppose that company X

generated $900 million in revenues over the course of that year. The asset turnover ratio for
company X is therefore:

10)

$900million/[($500million+$400million)/2]=

$900million/[$900million/2]=
$900 million / $450 million = 2.00

11)

The asset turnover ratio tends to be higher for companies in certain sectors than in others.

Retail, for example, is the sector that most often yields the highest asset turnover ratios,
scoring a 2.05 in 2014. Both it and consumer staples have relatively small asset bases but
have high sales volume.

12)

Conversely, firms in sectors like utilities and telecommunications, which have large asset

bases, will have lower asset turnover. The financial sector, for example, often trails in its
asset turnover ratio, scoring a 0.08 in 2014.

13)
USING THE ASSET TURNOVER RATIO

14)

Consider the asset turnover ratio for Wal-Mart Stores Inc. (WMT). When the fiscal year

ended on January 31, 2014, Wal-Mart had total revenues of $476 billion. Wal-Marts total
assets were $203 billion at the beginning of that fiscal year and $205 billion at fiscal yearend, for an average of $204 billion. Wal-Marts asset turnover ratio was therefore 2.36 ($476
billion/ $204 billion).

15)

In contrast, AT&T Inc. (T) had total revenues of $132 billion when the fiscal year ended

on December 31, 2014. Total assets at the beginning and end of the 2014 fiscal year were
$278 billion and $293 billion respectively, for an average asset base of $287 billion. AT&Ts
asset turnover ratio in 2014 was therefore 0.46 ($132 billion / $287 billion).

16)

Clearly, it would not make much sense to compare the asset turnover ratios for Wal-Mart

and AT&T, since they operate in very different industries. But comparing the asset turnover
ratios for AT&T and Verizon Communications Inc. (VZ), for instance, may provide a clearer
picture of asset use efficiency for these telecom companies. In the same fiscal year as in the
AT&T example above, Verizon had total revenues of $127 billion. Total assets at the
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beginning and end of the year were $274 billion and $232 billion, respectively, for an average
asset base of $253 billion. As such, in 2014 Verizons asset turnover ratio was 0.50 ($127
billion / $253 billion), about 9% higher than AT&Ts in the same year.

17)

Yet, this kind of comparison does not necessarily paint the clearest possible picture. It is

possible that a companys asset turnover ratio in any single year differs substantially from
previous or subsequent years. For example, while AT&Ts asset turnover ratio was 0.30 in
2006, it rose nearly a full fifty percent to reach 0.44 in 2007, the following year. For any
specific company, then, one would do well to review the trend in the asset turnover ratio over
a period of time to check whether asset usage is improving or deteriorating.

18)

Many other factors can affect a companys asset turnover ratio in a given year, such as

whether or not an industry is cyclical.

19)
HISTORY

20)

The Asset Turnover ratio is a key component of DuPont analysis, a system that

the DuPont Corporation began using during the 1920s. DuPont analysis breaks down Return
on Equity (ROE) into three parts, one of which is asset turnover, the other two being profit
margin and financial leverage. In splitting ROE into distinct components, this form of
analysis allows one to analyze the nuances of a high or low ROE, to attempt to determine
what causes may be contributing to a companys ROE performance and to compare the
components of ROE with those of other companies.

21) FIXED ASSETS TURNOVER RATIO:

22)

The fixed-asset turnover ratio is, in general, used by analysts to measure operating

performance. It is a ratio of net sales to fixed assets. This ratio specifically measures how
able a company is to generate net sales from fixed-asset investments, namely property, plant
and equipment (PP&E), net of depreciation. In a general sense, a higher fixedasset turnover ratio indicates that a company has more effectively utilized investment in fixed
assets to generate revenue.The fixed-asset turnover ratio is calculated as:

23)
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24)

FORMULA:

25)
26)

Fixed Assets Turnover Ratio =

Sales / Cost of Goods Sold

27)

Fixed Assets

12

28)

BREAKING DOWN 'FIXED-ASSET TURNOVER RATIO'

The fixed-asset turnover ratio is commonly used as a metric in manufacturing industries that
make substantial purchases for PP&E in order to drive up output. When a company makes such
significant purchases, wise investors closely monitor this ratio in subsequent years, to observe the
effectiveness of such an investment in fixed assets.
In general, investments in fixed assets are representative of the sole, largest component of the
companys total assets. The ratio, calculated on an annual basis, is constructed in a way that is
purposeful in reflecting how efficiently a company, primarily the companys management team,
has used these substantial assets to generate revenue for the firm.

INDICATIONS OF THE FIXED-ASSET TURNOVER RATIO

While a higher ratio is indicative of greater efficiency in managing fixed-asset investments, there
is not an exact number or range that dictates whether a company has been efficient at generating
revenue from such investments. For this reason, it is important for analysts and investors to
compare a companys most recent ratio to both the historic ratios of the company and to ratio
values from peer companies and/or industry averages.
Though the fixed-asset turnover ratio is of significant importance in certain industries, an investor
or analyst must determine whether the specific company is the right type for the ratio being used,
before attaching any weight to it. Fixed assets vary drastically from one company to the next. As
an example, consider the difference between an Internet company and a manufacturing company.
An Internet company, such as Facebook, has a significantly smaller fixed-asset base than a
manufacturing giant such as Caterpillar. Clearly, in this example, Caterpillars fixed-asset
turnover ratio is of more relevance, and should hold more weight, than that of Facebooks.

VARIATIONS ON THE RATIO

Some asset-turnover ratios utilize total assets in the equation instead of fixed assets. However, the
latter acts as a representative of a multiplicity of a firms managements decisions on capital
expenditures, because it is such a significant element in the firms balance sheet. A fixed-asset
investment is a capital investment, but more importantly, the results of the capital investment are
a greater indicator of performance, more so than that evidenced by total asset turnover.

29) CAPITAL TURNOVER RATIO/ NET ASSET TURNOVER RATIO:

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Formula:
Capital Turnover Ratio = Sales / Cost of Goods Sold
Net Assets
This ratio indicates the firms ability of generating sales/ cost of goods sold per rupee of long
term investment. The higher the ratio, the more efficient is the owners and long-term creditors
funds. Net Assets includes Net Fixed Assets and Net Current Assets (Current Assets- Current
Liabilities). Since Net Assets equals to capital employed it is also known as Capital Turnover
Ratio.

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30) CURRENT ASSETS TURNOVER RATIO:

Current Asset Turnover - an activity ratio measuring firms ability of generating sales
through its current assets (cash, inventory, accounts receivable, etc.). It can be calculated by
dividing the firm's net sales by its average current assets, and it shows the number of turns
made by the current assets of the enterprise.
The values may vary between businesses and industries, and the normative value is absent.
However, higher current asset turnover comparing to competitors would indicate a high
intensity of the current assets usage. The increasing trend of this ratio is a good sign because
this means that the company is working on the consistent improvement of its policies in
inventory, accounts receivable, cash and other current assets management. In fact, increasing
current asset turnover leads to the decrease of the financial resources amount, needed for the
company's operations maintenance. This means that bigger part of the financial resources can
be used for current operations intensification or making investments. The decrease of the
current assets turnover indicates the firm's increasing need of sources of finance. If the access
to sources of finance is limited, this will cause the increase of the company's financial
expenses.
Resolving the problems with the current asset turnover exceeding the normative range:
In case the current asset turnover value is low there are following ways to increase it:

decreasing the inventory stock to the minimum level, which would allow the continuous
operational process;

sales promotion and decreasing the finished goods stock;

activation of the accounts receivable collection process, etc.

Formula :
Current Asset Turnover = Net Sales Average Current Assets
Current Assets Turnover Ratio stands Fourth in Performance ratio.

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31) WORKING

Working

capital

CAPITAL TURNOVER RATIO:

turnover

is

measurement

comparing

the depletion of working

capital used to fund operations and purchase inventory, which is then converted into sales
revenue for the company. The working capital turnover ratio is used to analyze the
relationship between the money that funds operations and the sales generated from these
operations. For example, a company with current assets of $10 million and current
liabilities of $9 million has $1 million in working capital, which may be used
in fundamentalanalysis.
Formula:
Working Capital Turnover Ratio = Sales / Cost of Goods Sold
Working Capital

BREAKING DOWN 'WORKING CAPITAL TURNOVER'

The working capital turnover ratio measures how well a company is utilizing its working capital
for supporting a given level of sales. Because working capital is current assets minus current
liabilities, a high turnover ratio shows that management is being very efficient in using a
companys short-term assets and liabilities for supporting sales. In contrast, a low ratio shows a
business is investing in too many accounts receivable (AR) and inventory assets for supporting its
sales. This may lead to an excessive amount of bad debts and obsolete inventory.
Calculating Working Capital Turnover
When calculating a companys working capital turnover ratio, the amount of net sales is divided
by the amount of working capital. The calculation is typically made on an annual or trailing 12month basis and uses the average working capital during that time period. For example, Company
A has $12 million of net sales over the past 12 months. The average working capital during that

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time

was

$2

million.

The

calculation

of

its

working

capital

turnover

ratio

is

$12,000,000/$2,000,000 = 6.

PROS AND CONS OF HIGH WORKING CAPITAL TURNOVER

A high working capital turnover ratio shows a company is running smoothly and has limited need
for additional funding. Money is coming in and flowing out on a regular basis, giving the
business flexibility to spend capital on expansion or inventory. A high ratio may also give the
business a competitive edge over similar companies.
However, an extremely high ratio, typically over 80%, may indicate a business does not have
enough capital supporting its sales growth. Therefore, the company may become insolvent in the
near future. The indicator is especially strong when the accounts payable (AP) component is very
high, indicating that management cannot pay its bills as they come due. For example, gold mining
and silver mining have average working capital turnover ratios of approximately 82%. Gold and
silver mining requires ongoing capital investment for replacing, modernizing and expanding
equipment and facilities, as well as finding new reserves. An excessively high turnover ratio may
be discovered by comparing the ratio for a specific business to ratios reported by other companies
in the industry.

32) INVENTORY / STOCK TURNOVER RATIO:

Inventory turnover is a ratio showing how many times a company's inventory is sold and replaced
over a period of time. The days in the period can then be divided by the inventory turnover
formula to calculate the days it takes to sell the inventory on hand. It is calculated as sales divided
by average inventory. This Ratio also known as stock turnover ratio establishes the relationship
between the cost of goods sold during the year and average inventory held during the year. It
measures the efficiency with which a firm utilizes or manages its inventory.

Formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

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BREAKING DOWN 'INVENTORY TURNOVER'

Inventory turnover measures how fast a company is selling inventory and is generally compared
against industry averages. A low turnover implies weak sales and, therefore, excess inventory. A
high ratio implies either strong sales and/or large discounts.
The speed with which a company can sell inventory is a critical measure of business performance.
It is also one component of the calculation for return on assets (ROA); the other component is
profitability. The return a company makes on its assets is a function of how fast it sells inventory
at a profit. As such, high turnover means nothing unless the company is making a profit on each
sale.

INVENTORY TURNOVER EXAMPLE

Inventory turnover is calculated as sales divided by average inventory. Average inventory is
calculated as: (beginning inventory + ending inventory)/2. Using average inventory accounts for
any seasonality effects on the ratio. Inventory turnover is also calculated using the cost of goods
sold (COGS), which is the total cost of inventory. Analysts divide COGS by average inventory
instead of sales for greater accuracy in the calculation of inventory turnover. This is because sales
include a markup over cost. Dividing sales by average inventory inflates inventory turnover.

Approach 1: Sales Divided By Average Inventory

As an example, assume company A has $1 million in sales. The COGS is only $250,000. The
average inventory is $25,000. Using the first equation, the company has inventory turnover of $1
million divided by $25,000, or 40. Translate this into days by dividing 365 by inventory days. The
answer is 9.125 days. This means under the first approach, inventory turns 40 times a year, and is
on hand approximately nine days.

Approach 2: COGS Divided By Average Inventory

Using the second approach, inventory turnover is calculated as the cost of goods sold divided by
average inventory, which in this example is $250,000 divided by $25,000, or 10. The number of
inventory days is calculated by dividing 365 by 10, which is 36.5. Using the second approach,
inventory turns over 10 times a year and is on hand for approximately 36 days.
The second approach gives a more accurate measure, as it does not include a markup. Only
compare inventory turnover that uses the same approach for an apples-to-apples comparison

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AVERAGE INVENTORY
Average inventory is a calculation comparing the value or number of a particular good or set of
goods during two or more specified time periods. Average inventory is the mean value of an
inventory throughout a certain time period, which may vary from the median value of the same
data set.
Formula :
Average Inventory = Opening Stock + Closing Stock / 2

!--break--Since two points do not always accurately represent changes in inventory over different
time periods, average inventory is frequently calculated by using the number of points needed to
more accurately reflect activities across a certain amount of time.
For instance, if a business was attempting to calculate the average inventory over the course of
a fiscal year, it may be more accurate to use the inventory count from the end of each month,
including the base month. The values associated with each point are added together and divided
by the number of points, in this case 13, to determine the average inventory.
For example, when calculating a three-month inventory average, the business achieves the
average by adding the current inventory of $10,000 to the previous three months of inventory,
recorded as $9,000, $8,500 and $12,000, and dividing it by the number of data points, as follows:
($10,000 + $9,000 + $8,500 + $12,000) / 4
This results in an average inventory of $9,875 over the time period being examined.

AVERAGE INVENTORY ANALYSIS

The average inventory figures can be used as a point of comparison when looking at overall sales
volume. This allows a business to track inventory losses that may have occurred due to theft or
shrinkage, or due to damaged goods caused by mishandling. It also accounts for any perishable
inventory that has expired.

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MOVING AVERAGE INVENTORY

A company may choose to use a moving average inventory when it's possible to maintain a
perpetual inventory tracking system. This allows the business to adjust the values of the inventory
items based on information from the last purchase. Effectively, this helps compare inventory
averages across multiple time periods by converting all pricing to the current market standard.
This makes it similar to adjusting historical data based on the rate of inflation for more stable
market items. It allows simpler comparisons on items that experience high levels of volatility.
In the case of inventory of raw materials the inventory turnover ratio is calculated using the
following formula :
Raw Material Consumed
Average Raw Material Stock
This Ratio indicates that how fast inventory is used or sold. A high ratio is good from the view
point of liquidity and vice versa. A low ratio would indicate that inventory is not used/ sold/ lost
and stays in a shelf or in the warehouse for a long time.

33) RECEIVABLES ( DEBTORS) TURNOVER RATIO:

An accounting measure used to quantify a firm's effectiveness in extending credit and in
collecting debts on that credit. The receivables turnover ratio is an activity ratio measuring
how efficiently a firm uses its assets.
Receivables turnover ratio can be calculated by dividing the net value of credit sales during a
given period by the average accounts receivable during the same period. Average accounts
receivable can be calculated by adding the value of accounts receivable at the beginning of
the desired period to their value at the end of the period and dividing the sum by two.
The method for calculating receivables turnover ratio can be represented with the following
formula:

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The receivables turnover ratio is most often calculated on an annual basis, though this can be
broken down to find quarterly or monthly accounts receivable turnover as well.

BREAKING DOWN 'RECEIVABLES TURNOVER RATIO'

Receivable turnover ratio is also often called accounts receivable turnover, the accounts
receivable turnover ratio or the debtors turnover ratio.
In essence, the receivables turnover ratio indicates the efficiency with which a firm manages
the credit it issues to customers and collects on that credit. Because accounts receivable are
moneys owed on a credit agreement without interest, by maintaining accounts receivable
firms are indirectly extending interest-free loans to their clients. As such, because of thetime
value of money principle, a firm loses more money the longer it takes to collect on its credit
sales.
To provide an example of how to calculate the receivables turnover ratio, suppose that during
2014 Company A had $800,000 in net credit sales. Also suppose that on the first of January it
had $64,000 accounts receivable and that on December 31 it had $72,000 accounts
receivable. With this information, one could calculate the receivables turnover ratio for 2014
in the following way:
$800,000 / [($64,000 + $72,000) / 2] = $800,000 / ($136,000 / 2) = $800,000 / $68,000
= 11.76
This number also serves as an indicator of the number of accounts receivable a company
collects during a year. Because of this functionality, one can determine the
average duration of accounts receivable during a given year by dividing 365 by the
receivables turnover ratio for that year. For this example, the average accounts receivable
turnover is 31.04 days (365 / 11.76).

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INTERPRETING 'RECEIVABLES TURNOVER RATIO'

A high receivables turnover ratio can imply a variety of things about a company. It may
suggest that a company operates on a cash basis, for example. It may also indicate that the
companys collection of accounts receivable is efficient, and that the company has a high
proportion of quality customers that pay off their debts quickly. A high ratio can also suggest
that the company has a conservative policy regarding its extension of credit. This can often
be a good thing, as this filters out customers who may be more likely to take a long time in
paying their debts. On the other hand, a companys policy may be too conservative if it is too
tight in extending credit, which can drive away potential customers and give business to
competitors. In this case, a company may want to loosen policies to improve business, even
though it may reduce its receivables turnover ratio.
A low ratio, in a similar way, can also suggest a few things about a company, such as that the
company may have poor collecting processes, a bad credit policy or none at all, or bad
customers or customers with financial difficulty. Theoretically, a low ratio can also often
mean that the company has a high amount of cash receivables for collection from its various
debtors, should it improve its collection processes. Generally, however, a low ratio implies
that the company should reassess its credit policies in order to ensure the timely collection of
imparted credit that is not earning interest for the firm.

USES OF 'RECEIVABLES TURNOVER RATIO'

The receivables turnover ratio has several important functions other than simply assessing
whether or not a company has issues collecting on credit. Though this offers important
insight, it does not tell the whole story. For example, if one were to track a companys
receivables turnover ratio over time, it would say much more about the companys history
with issuing and collecting on credit than a single value can. By looking at the progression,
one can determine if the companys receivables turnover ratio is trending in a certain
direction or if there are certain recurring patterns. What is more, by tracking this ratio over
time alongside earnings, one may be able to determine whether a companys credit practices
are helping or hurting the companys bottom line.
While this ratio is useful for tracking a companys accounts receivable turnover history over
time, it may also be used to compare the accounts receivable turnover of multiple companies.

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If two companies are in the same industry and one has a much lower receivables turnover
ratio than the other, it may prove to be the safer investment.

LIMITATIONS OF 'RECEIVABLES TURNOVER RATIO'

Like any metric attempting to gauge the efficiency of a business, the receivables turnover
ratio comes with a set of limitations that are important for any investor to consider before
using it.
One important thing to consider is that companies will sometimes use total sales instead
of net sales when calculating their ratio, which generally inflates the turnover ratio. While
this is not always necessarily meant to be deliberately misleading, one should generally try to
ascertain how a company calculates their ratio before accepting it at face value, or otherwise
should calculate the ratio independently.
Another important consideration is that accounts receivable can vary dramatically over the
course of the year. This means that if one picks a start and end point for calculating the
receivables turnover ratio arbitrarily, the ratio may not reflect the true climate of the
companys issuing of and collection on credit. As such, the beginning and ending values
selected when calculating the average accounts receivable should be carefully picked so as to
represent the year well. In order to account for this, one could take an average of accounts
receivable from each month during a twelve-month period.
It is also important to note that comparisons of different companies receivables turnover
ratios should only be made when the companies are in same industry, and ideally when they
have similar business models and revenue numbers as well. Companies of different sizes may
often have very different capital structures, which can greatly influence turnover calculations,
and the same is often true of companies in different industries. The receivables turnover ratio
is not particularly useful in comparing companies with significant differences in the
proportion of sales that are credit, as determining the receivables turnover ratio of a company
with a low proportion of credit sales does not indicate much about that companys cash flow.
Comparing such companies with those that have a high proportion of credit sales also does
not usually indicate much of importance.
Lastly, a low receivables turnover ratio might not necessarily indicate that the companys
issuing of credit and collecting of debt is lacking. If, for example, distribution messes up and
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fails to get the right goods to customers, customers may not pay, which would also decrease
the companys receivables turnover ratio.

34) RECEIVABLES ( DEBTORS) VELOCITY :

Debtors turnover ratio indicates the average collection period. However, the average
collection period can be directly calculated as follows:
RECEIVABLE VELOCITY/ AVERAGE COLLECTION PERIOD
=

Average Accounts Receivables / Average Daily Credit Sales

12months / 52 weeks / 360 days / Receivable turnover Ratio

OR
Average Daily Credit Sales = Average Daily Credit Sales = Credit Sales / No. of days in year
( say 360)
The average collection period measures the average number of days it takens to collect an
account receivable. This ratio is also referred to as the number of days of receivable and the
number of days sales in receivables.

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35) PAYABLES TURNOVER RATIO :

36)

The accounts payable turnover ratio is a short-term liquidity measure used to

quantify the rate at which a company pays off its suppliers. Accounts payable turnover
ratio is calculated by taking the total purchases made from suppliers, or cost of sales, and
dividing it by the average accounts payable amount during the same period.

37)

Formula:
38)

39)

BREAKING

DOWN 'ACCOUNTS PAYABLE TURNOVER RATIO'

40)

The measure shows investors how many times per period the company pays

its average payable amount. Accounts payable, also known as payables, represents short-term
debt obligations that a company must pay off. The accounts payable is listed under a
company's current liabilities on its balance sheet. Accounts payable are also part of
households because people may be subject to pay off their short-term debt provided by
creditors, such as credit card companies.
41)

INTERPRETATION

42)

If the turnover ratio is falling from one period to another, this is a sign that the

company is taking longer to pay off its suppliers than it was in previous time periods. The
opposite is true when the turnover ratio is increasing, which means that the company is
paying off suppliers at a faster rate.

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43)

EXAMPLE

For example, if company A made $100 million in purchases from suppliers during the
previous year, and at any given point it held an average accounts payable of $20 million, the
accounts payable turnover ratio for the previous accounting period was 5, or $100 million /
$20 million. Assume that during the current year, company A had cost of goods sold (COGS)
of $120 million, accounts payable of $30 million for the start of the accounting period, and
accounts payable of $50 million for the end of the period.
To calculate the average accounts payable for the fiscal year, sum the two accounts payable
amounts, and divide by two. Therefore, the average accounts payable was $40 million, or
($30 million + $50 million) / 2, for the current year. Consequently, the accounts payable
turnover ratio was 3, or $120 million / $40 million.
Assume that during the current year, company B, which is in the same industry as company
A, had COGS of $110 million, accounts payable of $20 million for the end of the accounting
period, and payables of $15 million for the start of the accounting period. This means that
company B had an average accounts payable of $17.50 million, or ($15 million + $20
million) / 2. Company B had an accounts payable turnover ratio of 6.29, or $110 million /
$17.50 million. Therefore, when compared to company A, company B is paying off its shortterm debt at a faster rate.

PAYABLE VELOCITY / AVERAGE PAYMENT PERIOD

It can be calculated as :
Average Accounts Payable
Average Daily Credit Purchases
Or

12months / 52 Weeks / 360 Days

Payables Turnover Ratio

In determining the credit policy, debtors turnover and average collection period provide a
unique guideline.

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The firm can compare what credit period it receives from the suppliers and what it offers to
the customers. Also it can compare the average credit period offered to the customers in the
industry to which it belongs.
The above three ratios i.e Inventory Turnover Rartio Receivables Turnover Ratio is also
relevant to examine liquidity of an organization.
ILLUSTRATIONS

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BIBLIOGRAPHY

www.edupristine.com Blog Financial Modeling

www.accountingedu.org/accounting-ratios.html
http://shodhganga.inflibnet.ac.in/bitstream/10603/705/11/12_chapter
3.pdf
http://www.investopedia.com/terms/a/assetturnover.asp
http://www.careerride.com/fa-debt-equity-ratio-explained.aspx
https://www.finstanon.com/ratios-dictionary/74-current-assetturnover
STUDY MATERIAL OF IPCC( ICAI)

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