We next turn our attention to the efficiency with which Prufrock uses its assets. The measures in this section are sometimes called asset utilization ratios. The specific ratios we discuss can all be interpreted as measures of turnover. What they are intended to describe is how efficiently or intensively a firm uses its assets to generate sales. We first look at two important current assets: inventory and receivables.
Inventory Turnover and Days’ Sales in Inventory During the year, Prufrock had a cost of goods sold of $1,344. Inventory at the end of the year was $422. With these numbers, inventory turnover can be calculated as follows:
In a sense, Prufrock sold off or turned over the entire inventory 3.2 times.4 As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing inventory.
If we know we turned our inventory over 3.2 times during the year, we can immediately figure out how long it took us to turn it over on average. The result is the average days’ sales in inventory:
Page 63This tells us that, roughly speaking, inventory sits 115 days on average before it is sold. Alternatively, assuming we have used the most recent inventory and cost figures, it will take about 115 days to work off our current inventory.
To give an example, in December 2013, the U.S. automobile industry as a whole had a 54-day supply of cars, less than the 60-day supply considered normal. This figure means that at the then-current rate of sales, it would have taken 54 days to deplete the available supply. Of course, there is significant variation across models, with newer, hotter-selling models in shorter supply (and vice versa). So, also in December 2013, the Nissan LEAF had only 13 days of sales compared to 232 days for the Cadillac ATS.
It might make more sense to use the average inventory in calculating turnover. Inventory turnover would then be $1,344/[($393 + 422)/2] = 3.3 times.5 It depends on the purpose of the calculation. If we are interested in how long it will take us to sell our current inventory, then using the ending figure (as we did initially) is probably better.
In many of the ratios we discuss in this chapter, average figures could just as well be used. Again, it depends on whether we are worried about the past, in which case averages are appropriate, or the future, in which case ending figures might be better. Also, using ending figures is common in reporting industry averages; so, for comparison purposes, ending figures should be used in such cases. In any event, using ending figures is definitely less work, so we’ll continue to use them.
Receivables Turnover and Days’ Sales in Receivables Our inventory measures give some indication of how fast we can sell product. We now look at how fast we collect on those sales. The receivables turnover is defined much like inventory turnover:
Loosely speaking, Prufrock collected its outstanding credit accounts and reloaned the money 12.3 times during the year.6
This ratio makes more sense if we convert it to days, so here is the days’ sales in receivables:
Therefore, on average, Prufrock collects on its credit sales in 30 days. For obvious reasons, this ratio is frequently called the average collection period (ACP).
Note that if we are using the most recent figures, we could also say that we have 30 days’ worth of sales currently uncollected. We will learn more about this subject when we study credit policy in a later chapter.