The Foundation
3.4 Asset Management Ratios
56 THEFOUNDATION
Concept Check 3.3
1 What do debt management ratios tell us about a firm? What are the most com- monly used ratios that measure a firm’s liquidity?
2 What is the major limitation of leverage ratios (such as the debt ratio and long-term debt ratio) that are based solely on the balance sheet items?
3 Ambient Technologies has liquidity and debt management ratios that either exceed or are consistent with industry norms. Yet, analysts fear that rating agencies may lower Ambient’s bond rating. Why might such a downgrade occur despite apparent strength in liquidity and debt management ratios?
likelihood of collecting outstanding receivables. Those receivables that have been outstand- ing the longest time often have the lowest likelihood of eventual collection. We discuss the aging of accounts receivables in greater detail in Chapter 6.
Average accounts receivable is used in the denominator because the net credit sales is a cumulative sales number that reflects operations over one year, while a balance sheet item reflects the amount at the end of the fiscal year. Averaging a firm’s monthly or quarterly receivables over the year typically yields a better estimate of the receivables outstanding during the year. One common approach to determining average accounts receivable is to add the beginning and ending amounts for the period and divide by two.
To compute Home Depot’s accounts receivable turnover ratio requires estimating net credit sales. As mentioned previously, if a firm does not report its net credit sales, analysts sometimes use total net sales to compute the ratio. This assumption may be reasonable for a manufacturing firm whose sales are mostly credit sales, but not for a retail firm with a majority of cash sales. Most of Home Depot’s sales are either immediate cash sales or credit card sales that provide cash to the company in a few days; credit sales that result in accounts receivable are probably low. Home Depot’s credit sales come largely from sales to commercial customers and from sales on their private label credit card. To calculate the accounts receiv- able turnover ratio, we assume 25 percent of sales are on credit and get an accounts receivable turnover ratio of 14.62 times.
Accounts receivable turnover ratio =
(58,247)(0.25) (920 1072)
2
+ = 14.62 times
A variant of the accounts receivable turnover ratio is the receivables collection period, which is computed by dividing 365 by the accounts receivable turnover ratio.
Receivables collection period =
365
Accounts receivable turnover ratio (3.12) As its name suggests, the receivables collection period indicates how many days a firm takes to convert accounts receivable into cash. If the receivables collection period exceeds a firm’s credit terms, this may indicate that a firm is ineffective in collecting its credit sales or is granting credit to marginal customers. The receivables collection period for Home Depot is 24.97 days.
Receivables collection period =
365
14.62 = 24.97 days Inventory Turnover Ratio
The inventory turnover ratio is computed by dividing the cost of goods sold by the average inventory.
Inventory turnover ratio =
Cost of goods sold
Average inventory (3.13)
58 THEFOUNDATION
A high inventory turnover ratio, relative to some benchmark, suggests efficient manage- ment of the firm’s inventory. A low, declining ratio may suggest the firm has continued to build up inventory in the face of weakening demand or may be carrying and reporting outdated or obsolete inventory that could only be sold at reduced prices, if at all. On the other hand, a manager or analyst should check to make sure that a high ratio does not reflect lost sales opportunities because of inadequate inventory levels caused by production problems, poor sales forecasting, or weak coordination between sales and production activi- ties within the firm. The advent of computer inventory systems in recent years has allowed many firms to keep inventory levels to a minimum.
The inventory turnover ratio for Home Depot for fiscal year 2002 was 5.33 times.
Inventory turnover ratio =
40,139 ( ,6 725 ,8 338)
2
+ = 5.33 times
The inventory processing period is computed by dividing 365 by the inventory turn- over ratio.
Inventory processing period =
365
Inventory turnover ratio (3.14)
The inventory processing period indicates the average number of days a firm takes to process and sell its inventory. The inventory processing period for Home Depot was 68.48 days.
Inventory processing period =
365
5 33. = 68.48 days Accounts Payable Turnover Ratio
The accounts payable turnover ratio is computed by dividing the cost of goods sold by the average accounts payable for the firm.
Accounts payable turnover ratio =
Cost of goods sold
Average accounts payable (3.15)
This ratio measures how many times a firm’s accounts payable are generated and paid during the year. In general, as long as a firm pays its bills in a timely manner and satisfies its financial obligations to its suppliers, the lower the payables turnover ratio the better.
The accounts payable turnover ratio for Home Depot for fiscal year 2002 was 10.04 times.
Accounts payable turnover ratio =
40,139 ( ,3 436 ,4 560)
2
+ = 10.04 times
The accounts payable payment period can be computed by dividing 365 by the accounts payable turnover ratio.
Accounts payable payment period =
365
Accounts payable turnover ratio (3.16) The accounts payable payment period measures how long, on average, a firm takes to pay its accounts payable. Think of the accounts payable payment period as the counterpart to the average collection period. In general, higher accounts payable payment periods are bene- ficial to the firm as accounts payable are a low cost source of funds for the firm. The average accounts payable payment period for Home Depot is 36.35 days.
Accounts payable payment period =
365
10 04. = 36.35 days
When a firm produces goods or acquires inventory for sale and/or sells the items on a credit basis, it will need to have ample cash during the period between when the firm must pay for the raw materials, inventory, and labor and when it receives cash from the sale of the goods. The receivables, inventory, and payables “periods” can be combined to determine the length of time that the cash is tied up in this cycle, a time period defined as the cash conversion cycle for the firm:
Cash conversion
cycle
Receivables collection period
Inventory processing period
Accounts payable payment period
= ⎛
⎝⎜
⎞
⎠⎟ + ⎛
⎝⎜
⎞
⎠⎟ − ⎛
⎝⎜
⎞
⎠⎟ (3.17)
Thus, the cash conversion cycle is the length of time a company’s cash is tied up in the business. A firm’s management can reduce its cash conversion cycle and free up cash for other activities by collecting its receivables more promptly, reducing the inventory process- ing time, or lengthening the time required to pay its suppliers. The cash conversion cycle increases when firms take longer to process inventory (buy and process raw materials, acquire inventory for sale, and make the eventual sale) and to collect the accounts receiv- able generated from credit sales. This cash conversion cycle correspondingly decreases by the amount of time the firm takes to pay its associated expenses associated with the sale of these goods (trades payable).
A cash conversion cycle for Home Depot is computed below:
Cash conversion cycle = 24.97 + 68.48 − 36.35 = 57.10 days Asset Turnover Ratios
Other asset management measures include two ratios that measure how efficiently manage- ment is using its fixed assets and total assets to generate sales. The fixed asset turnover and total asset turnover ratios are computed by dividing net sales by the appropriate asset figure:
Fixed asset turnover ratio =
Net sales
Average net fixed assets (3.18)
60 THEFOUNDATION
3 To calculate accounts receivable turnover, we assume that 10 percent of net sales for Lowe’s are net credit sales (we assumed 25 percent for Home Depot). We assumed a lower amount because Lowe’s discloses that sales made through their private label credit card are not reflected in accounts receivables.
Total asset turnover ratio =
Net sales
Average total assets (3.19)
The fixed asset turnover ratio indicates how effectively a firm’s management uses its net fixed assets to generate sales. Similarly, the total asset turnover ratio indicates how effec- tively management uses total assets to generate sales. For example, a fixed asset turnover of 2.0 times would indicate that the firm generates $2.00 of net sales for each dollar invested in net fixed assets. Higher asset turnover ratios generally indicate more efficient use of the firm’s assets. However, biases may occur due to the historic cost accounting principle used for a firm’s fixed assets. A firm with older plant and equipment will have higher asset turnover ratios as the equipment is depreciated and reported on the balance sheet at a low book value, especially under periods of high inflation. Thus, a high asset turnover ratio may simply indicate that a firm needs to replace aging plant and equipment. Biases may also result from the depreciation method used and the extent to which a firm leases rather than owns its fixed assets.
The fixed asset and total asset turnover ratios for Home Depot are computed below:
Fixed asset turnover ratio =
58,247 ( ,15 375 17 168, )
2
+ = 3.58 times
Total asset turnover ratio =
58,247 (26 394, 30 011, )
2
+ = 2.07 times
Analyzing Asset Management Ratios for Home Depot
Table 3.3 reports the asset management ratios for Home Depot and Lowe’s.3 Both companies appear to be managing their assets efficiently with similar receivables collection periods, Table 3.3 Asset management ratios for Home Depot and Lowe’s for FY 2002
Asset management ratios Home Depot Lowe’s
Accounts receivable turnover 14.62 x 15.68 x
Receivables collection period 24.97 days 23.29 days
Inventory turnover 5.33 x 4.87 x
Inventory processing period 68.48 days 74.95 days
Accounts payable turnover 10.04 x 10.10 x
Payable payment period 36.35 days 36.14 days
Cash conversion cycle 57.10 days 62.10 days
Fixed asset turnover 3.58 x 2.79 x
Total asset turnover 2.07 x 1.78 x
inventory processing periods, and payables payment periods. Both firms have cash conversion cycles of around 60 days. With higher fixed asset and total asset turnover ratios, Home Depot creates more sales per dollar invested in both its fixed assets and total assets than Lowe’s.
Concept Check 3.4
1 What do asset management ratios tell about a firm? What are the most commonly used asset management ratios?
2 What can a firm do to improve (shorten) its cash conversion cycle? Would you expect an improvement in a firm’s cash conversion cycle to increase the value of the firm?
3 Suppose a retail firm’s credit sales are only 5 percent of total net sales. If you assume all net sales are credit sales, how would this distort the calculation of the firm’s accounts receivable turnover ratio and cash conversion cycle?