B. Activity Ratios
1. Inventory Turnover
Inventory turnover is a ratio that indicates the turnover rate of inventory in a given period (e.g. one year).Â
This ratio is obtained by dividing the value of Cost of goods sold (COGS) with inventory.
From the Income Statement and Balance Sheet “danieel.id Company”, in 2019, we can calculate its Inventory Turnover = $4,355/$560 = 7.74
This means that in one year, there are 7.7 times inventory turnover in this Company.
Another commonly used approach to measuring this activity is the average age of inventory, which is to divide the number of days in a year (365) by the ratio of inventory turnover.
In case “danieel.id Company” this means 365/7.74 = 47.2 days.
This means that the average inventory at the Company lasts 47 days before it is finally sold.
The ideal range or value for this number certainly varies according to the type of business and its product. Stores or food / beverage companies for example whose products are relatively faster damaged so that they must be sold quickly, will have a higher Inventory Turnover value than for example automotive companies.
2. Average Collection Period
Average Collection Period is a ratio that indicates the average life of a receivable account in a Company.
The formula of this ratio is as follows:
We apply this formula to “danieel.id Company, then obtained the Average Collection Period of this Company in 2019 is $ 920 / ($6,115/365) = 54.91 days.
This figure means that on average it takes 54.9 days for a company “danieel.id Company” to collect its receivables.
This figure is strongly related to the credit-term policy (or term of payment given to the customer) applied by the Company, If let’s say most customers are given a term of payment of 60 days, then the average collection days of 54.9 days is a pretty good number, because it means the average customer pays faster than due-date debt.
However, if most of the terms of payment given by this Company to its customers are 30 days, then the number 54.9 days is a poor collection performance figure.
(Below we will compare also in time-series and similar industry average numbers)
The term of payment is part of the Company’s sales strategy, and is very dependent also on the competition situation in the market, on the one hand the Company must provide attractive offers to customers (both in terms of selling price and term of payment), while other credit sales can also be seen as a kind of providing interest-free debt to customers. These two sides should be able to be balanced and managed properly.
Note: sales referred to in the Average Collection Period formula can be in the form of total sales or only credit-sales. The meaning will be slightly different.
If the total sales (cash & credit sales) will be obtained the average value of collection on the sales of a company as a whole, the more sales are made in cash, the average collection period value will decrease.
This is easier to do to compare the value of several similar companies, because in the company’s financial statements (in the Income Statement section), Sales Revenue is not distinguished whether it comes from credit sales or cash sales.
However, the figures obtained in this way cannot be used specifically to assess the performance of a Company in collecting its receivable accounts, and become less relevant when compared to the duration of the term of payment provided by the Company for the sale of its credits.
If necessary to assess the performance of a company in collecting its receivables, the value of sales used is credit sales.Â
3. Average Payment Period
Average Payment Period is a ratio that indicates the average life of debt to vendors (payable accounts) in a Company.
The average payment period formula is as follows:
It is rather difficult to calculate this value directly from the Financial Statements of a Company, because the annual purchase value is not listed in the report. Generally the annual purchase value approach is a certain percentage of the Cost of goods sold (COGS).
For the case “danieel.id Company” let’s assume the annual purchase is 65% of the COGS value, then in 2019 the value of the Company’s Average Payment Period is : $ 453 / ((0.65 x $ 4,335)/365)) = 41.6 days.
Just like the Average Collection Period, this figure will be more meaningful when compared to the credit-term given by the Supplier to this company.
If the average supplier gives a credit-term (term of payment) for 60 days, then the figure of 41.6 days is good, because the Company pays faster, and vice versa if the average credit-term given by the supplier is 30 days, then the credit-rating of this Company will be bad, because it pays the bill too long.
In another point of view, in cash flow, the average payment period number can also be compared to the Average Collection Period,
If the Average Collection Period can be viewed as a kind of giving interest-free debt to the customer, then the Average Collection Period is the opposite, it can be viewed as a kind of debt given by the supplier without interest.
In the case “danieel.id Company” in 2019, the Average Payment Period was 41.60 days, smaller than its Average Collection Period (54.91 days).
If viewed from this point of view, in cash flow, the Average Payment Period is not good, because the company pays debt (payable account) faster than the company’s ability to collect its receivable account.
(Below we will compare also in time-series and similar industry average numbers)
4. Total Asset Turnover
Total Asset Turnover is a ratio that indicates the effectiveness of a company in using its asset assets to generate sales.
The formula is as follows:
From the Income Statement and Balance Sheet “danieel Company”, we can calculate the Total Asset Turnover of this company in 2019 is : $ 6,115 / $ 11,025 = 0.55
In general, the bigger this number means the better.
If a company has a lot of assets, but its assets are mostly unproductive and do not support increased sales, then this ratio will tend to be smaller than similar industries.
Summary Activity Ratios
Here is a summary of Activity Ratios “danieel.id Company” when compared to the previous year (time-series) and similar industry averages.
We can see in the table above, for Inventory Turnover, the performance of “danieel.id Company” 2019 increased compared to the previous year, and the ratio (7.74) is better than the average of similar industries in 2019 (6.6).
For the Average Collection Period, in 2019 the number increased to 54.91 days, compared to the previous year’s 47.59 days,
This is certainly a less good indication, indicating that the Company in the reporting year (2019) took longer to collect its receivable account.
This could be because some customers are late in making payments, or it could be because the Company deliberately relaxes its term of payment policy to attract customers amid tight competition.
When compared to the equivalent Industry average (44.3 days), the Average Collection Period ratio in 2019 is also higher, this can be a warning for this Company to improve the performance of its receivable collection.
For the Average Payment Period, in the table above we see the number decreased compared to the previous year, (from 51.31 days in 2018 to 41.60 days in 2019), this can generally be said to be good in terms of credit-rating, because the Company in the reporting year made faster payments to suppliers. This figure is also much lower than the average of similar industries (66.5 days).
But as we discussed earlier, paying suppliers too quickly (compared to the Average Collection Period) can burden the Company’s cash flow.
For Total Asset Turnover, the Company’s Performance in 2019 decreased slightly compared to the previous year (0.55 in 2019 compared to 0.57 in 2018), and this ratio is also lower than the average of similar industries (0.75).Â
This shows that the Company has not been effective enough to use its asset assets in generating sales.
It could be because some of the Company’s assets are unproductive assets, or assets that do not play a role either directly or indirectly to increase sales.
The low Total Asset Turnover ratio can also be caused, among others, because the production capacity of the factory has not been maximized.
(This is for example due to miscalculation, building a factory with a capacity greater than demand, or sales that are not as large as originally expected)
Or it could be because the new company is making a new investment (building a new factory or making new machinery), where the factory or new machine is still in the construction stage, so it has not played a role in producing products to increase sales.
This Total Asset Turnover Ratio can be a warning for the Company’s management to be more effective and efficient in using the Company’s exploit assets to generate sales, careful in choosing the right new investment (which provides the best return), including if necessary considering divesting (selling) assets that are less productive.
Next let’s discuss Debt Ratios on page 3
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