Part 3: Basic financial ratios you should know as an investor
In part 1, we looked at profitability ratios which focused mainly on the financial performance of a company. Then, in part 2, we looked at liquidity and leverage ratios which tells us more about a company’s financial position. But to really get the full picture, investors should alos consider looking at the business activity ratios. Looking at various aspects of a company gives a more holistic representation of a company.
Business activity ratios indicate how successfully a company is utilising its assets to generate revenues. Here, we look at three ratios: Receivables Turnover Days, Payables Turnover Days, and Inventory Turnover Days. Together, they make up the cash conversion cycle.
Receivables Turnover Days
Receivables Turnover Days = Trade Receivables / ( Total Revenue / 365 )
The Receivables Turnover Days measures the average number of days a company takes to collect its trade receivables. A lower value means a company takes fewer days to collect from its trade debtors. This number becomes significant when a company has a high amount of trade receivables.
It may be meaningful to monitor receivables turnover for major customers to assess if the credit terms extended to customers are appropriate and identify customers that consistently delay payment. A faster Receivables Turnover Days would put the company in a better cash flow position. It is also important to compare this value to the credit terms the company offers to its customers for a more complete picture.
Payables Turnover Days
Payables Turnover Days = Trade Payables / ( Total Cost of Goods Sold / 365 )
The Payables Turnover Days measures the average number of days a company takes to pay off its trade payables. The lower the Payables Turnover Days is, the faster the company takes to pay its trade creditors.
Maintaining a healthy Payables Turnover Days requires a balance between maintaining healthy cash position in the company and keeping its trade creditors happy for a good working relationship. Better relationships with creditors could lead to better credit terms which will benefit the company positively. This value differs from industry to industry and it is important to benchmark this ratio to the credit terms usually offered by suppliers to assess the financial health of a company.
Inventory Turnover Days
Inventory Turnover Days = Total Inventory / (Total Cost of Goods Sold / 365)
The Inventory Turnover Days measures the average number of days a company takes to use or sell its inventory. In general, a higher number indicates a greater sales efficiency and a lower risk of accumulating obsolete stock.
However, an Inventory Turnover Days that is too high compared to industry norms may suggest that the company is not maximising its profits and may even hint at poor customer service. This value, again, is highly variable from industry to industry. Ordinarily, inventory that fetches a low gross profit margin requires a higher inventory turnover in order to achieve an adequate return on invested capital.
So with all of these ratios in mind, you should have a clearer idea of how financially sound a company is before investing in it!