Turnover Ratios
The turnover ratios answer the question, “How many times have you gone through the asset in one year?” “How many times have you exhausted a resource and then replaced it within a year?”
Working Capital Turnover Ratio
The working capital turnover ratio answers the question, “Within one year, how many times did you go through your working capital and then replace it?”
Working Capital Turnover Ratio = Net Sales / Working Capital
Since it’s called the working capital turnover ratio, that’s what goes into the denominator.
Our working capital is $12,000 as mentioned before. Let’s say that our net sales are $102,000. $102,000 divided by $12,000, so our working capital turnover is 8.5. That means that in the course of a year, we used our working capital and then replaced it 8.5 times.
Asset Turnover Ratio
The next turnover ratio is the asset turnover ratio, which tries to answer, “How much in net sales did we generate from our total assets?”
Asset Turnover Ratio = Net Sales / Total Assets
Earlier we listed the current assets of $22,000. Now let’s add in some non-current assets.
Let’s say that we have $25,000 of fixed assets and $5,000 of long-term deposits, meaning our total assets are $52,000. For the asset turnover ratio, we take the net sales of $102,000 and divide it by our assets of $52,000, which is rounded to about 2.0. That means that we used our total assets to generate two times as much net sales.
Accounts Receivable Turnover Ratio
Let’s jump into the accounts receivable turnover ratio. This ratio answers the question,
“How many times do we collect our AR balance per year?”
Accounts Receivable Turnover Ratio = Net Credit Sales / Average AR Balance
Net credit sales are $102,000. Let’s say the AR balance is $10,000. Then our AR turnover ratio is 10.2, meaning that every year we collect our AR 10.2 times. Then to convert it into the number of days outstanding in AR we take 365 and divide it by 10.2, which is roughly about 36, meaning that every 36 days we’re collecting our AR balance.
Inventory Turnover Ratio
The next turnover ratio is the inventory turnover ratio, which asks, “How many times do we sell our inventory and then replace it in a year?” We measure this because we don’t want to hold onto inventory for too long because then we’re using up warehouse space and maybe then the inventory goes obsolete.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Let’s say that our cost of goods sold amount is $30,600, and our inventory balance is $7,000. That means that our inventory turnover is 4.4. This means that within one year we got rid of our inventory and then replaced it 4.4 times.
Then we turn this into the days in inventory amount. We take 365 divided by 4.4 for 83.
Meaning that on average every 83 days, our inventory is sold and then replaced.
Accounts Payable Turnover Ratio
The next turnover ratio is accounts payable turnover, which is simply the cost of goods sold divided by accounts payable.
Accounts Payable Turnover Ratio = Cost of Goods Sold / Average Accounts Payable
Let’s say that our accounts payable is $6,000. For the ratio, $30,600 divided by $6,000 equals 5.1, which means that on average, we pay our AP balance 5.1 times per year. Then to get the days in payables amount, we take 365 and divide it by 5.1. Meaning that our answer is 72 days. On average, we pay our AP balance every 72 days.
Cash Conversion Cycle
A key part of figuring out your cash flow is by calculating the cash conversion cycle.
Before we go into it, we have to think about what happens in the general operations of a manufacturing company. A company first buys inventory to create the products. Then the company manufactures the products. After that, it needs to sell the products, and then after selling the products, it needs to collect the AR balance. There are four different steps that are happening.
The cash conversion cycle asks the question, “How much time does it take between the first step of buying the inventory and the fourth step of actually collecting cash?” “How long does that process take?”
Cash Conversion Cycle = Days in Inventory + Days in AR – Days in AP
Our days in inventory were 83 days in the previous example. That’s how long it took us to manufacture the inventory and then replace it. Then we had to wait to collect the cash from the customers, which was on average 36 days. Then we were allowed to hold onto our cash for 72 days (Days in AP).
Now we throw these numbers into the formula:
Cash Conversion Cycle = 83 days + 36 days – 72 days = 47 days
Our cash conversion cycle is 47 days. That means that on average it takes us 47 days to buy the inventory, manufacture it, sell it, and then collect the cash.
