While liquidity ratios examine the solvency of the operations i.e. whether the operations of the company is self-sustaining or not, efficiency ratios deal with the efficiency of the company in managing their inventory and credit policies. Where liquidity ratios give us a snapshot of the liquidity of the operations, efficiency ratios deal with periods – generally a year. Let us start with some ration and at the end, we will discuss the Cash Conversion Cycle (CCC).
ACCOUNTS RECEIVABLE TURNOVER
Accounts Receivable Turnover = Net Sales / Average Accounts Receivable
Accounts Receivable is the amount you are expected to get from your customer for the supplies you already made.
Average Accounts Receivable= (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Accounts Receivable Turnover tells us about the company’s effectiveness in collecting payments from the customers. A higher ratio (i.e. lower average accounts receivable) means that the company is better at collecting payments. Like all ratios, this ratio should also be compared with the peers.
Days Sales Outstanding (DSO) = 365 / Accounts Receivable Turnover
DSO gives the average days a company takes to collect payments on their invoices to customers. A company may have a higher DSO for many reasons. A company may provide a longer credit period to its customers to compete in the market or simply lack the negotiating power with the customers. It can also happen that the company offers a lower credit period but is not capable to collect payments on time.
ACCOUNTS PAYABLE TURNOVER
Accounts Payable Turnover = Purchases on Credit / Average Accounts Payable
Accounts Payable is the amount you are supposed to pay to the suppliers for the goods and services already supplied.
Average Accounts Payable = (Beginning Accounts Payable + Ending Accounts Payable) / 2
Days Payables Outstanding (DPO) = 365 / Accounts Payable Turnover
DPO gives the average days the company takes to pay its suppliers after they receive the invoices from the suppliers. A longer DPO means that the company either have a higher negotiating power to get a longer credit period or is not efficient at paying suppliers on time. From a cash cycle point of view, a higher DPO is good but it may hurt the company’s relationship with the suppliers.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Cost of Goods Sold = Beginning Inventory + Purchase during the period – Ending Inventory
Average Inventory = (Beginning Inventory + Ending Inventory) /2
Days Inventory Outstanding (DIO) = 365 / Inventory Turnover
DIO gives us an idea about how long the company holds inventory before realising sales. For different industries, the DIO can be vastly different given the conversion of raw materials into products take vastly different time for different products. It gives us some idea about how long the company takes to process the inventory. It should be compared with the peers to understand the efficiency of the production process.
CASH CONVERSION CYCLE
Cash Conversion Cycle (CCC) = DSO + DIO – DPO
Consider at the beginning of a year a company starts its operation with Rs. 100. Now, the DSO for the company is 30 days and the DPO is 15 days. The company takes on an average 45 days to process the inventory i.e. the DIO is 45 days.
CCC = 30 days + 45 days – 15 days = 60 days.
Now, it means after every 60 days the company will get back the Rs. 100 (plus some profit margin) from the operations. What does it mean?
First of all, money is not free. Let us consider the cost of the capital for the Rs. 100 is 10% per annum.
Note: Even if it is the company’s own money, that money could have been invested somewhere to earn some return.
Now, for 60 days (~2 months) period, the cost for the Rs. 100
= Rs. 100 X (((1+0.1)^(2/12)) – 1)
= Rs. 1.6
That means for every cash cycle the inventory costs Rs. 1.6 of interest. The profit margin should be enough to pay for this cost along with the cost for the capital expenses such as plants and machinery.
A lowering or steady CCC is considered good where an increasing CCC is a source of concern and should be examined.