From: TomCrouser@aol.com
Date: Sun, 3 Nov 1996 10:17:38 -0500
Subject: Ratios: Accounts Receivable and Inventory Turnover
Content-Length: 14284
X-UIDL: 847122868.007

Crouser Report OnLine Copyright 1996 Thomas P. Crouser, November 3, 1996 -
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***** *****
Ratios: Accounts Receivable and Inventory Turnover
Transmitted from Owensboro, Kentucky

Actually had a request to expand upon Accounts Receivable and Inventory
financial ratios, so I took it. In this message we cover: DAYS SALES in
accounts receivable; accounts receivable AGING ANALYSIS; accounts receivable T
URNOVER; AVERAGE COLLECTION PERIOD; a clarification of exactly what is CHARGE
SALES; INVENTORY TURNOVER; and putting them all together in a PERSPECTIVE.
Happy Financial Analysis to you and yours.
*****
Subj:	RATIOS
From:	Arty
To: 	tomcrouser@aol.com

I have been following with interest the discussion on ratios.  I understand
current ratios.  You mentioned 

Days in AR and an aging analysis of
receivables as well as Inventory Turns

.  I have heard of these before but
how does one measure them and what is considered healthy?  Thank you. Arty
*****
Thanks for the question. The current ratio along with measurements of
accounts receivable and inventory are among the ratios used to judge the
ability of the company to pay short term debt. You could have a good current
ratio, as one reader pointed out, but still have problems. How? Maybe your
accounts receivables or inventory aren't really very secure. How to judge?
Well, that's your question and here's the answer.
*****
DAYS SALES IN ACCOUNTS RECEIVABLE 
There are several different calculations which can be used to judge the
strength of accounts receivable. I usually start with DAYS SALES IN ACCOUNTS
RECEIVABLE and calculate it in a way which is easiest for me. For instance:

If you normally have charge sales of $1,000 per day and your ending accounts
receivable balance is $30,000, then it can be said, although not with
precision, that you have 30 business DAYS SALES IN ACCOUNTS RECEIVABLE
($30,000 divided by $1,000).  If your terms are net 30 days, then it would
appear that your accounts receivable are in line with your terms. However, I
am mixing calendar days with business days. While the above is a quick
calculation, there's only about 20-22 business days per calendar month which
has some 30 days. So, by dividing the 30 days from the above example, by 22
business days, one would find about 1.36 months in accounts receivable or 41
CALENDAR DAYS (1.36 x 30). Note: There are alternative and more precise ways
to calculate this same information. I do it this way only because it is
quickest and easiest for me resulting in a very close approximation. See
below for other methods.

WHAT'S GOOD OR BAD? 
If your terms of sale is net 30 (calendar) days, and if you find you have 60
calendar days in accounts receivable, then that's bad. Someone is not paying
you according to terms. Generally, I see anywhere from 30 to 40ish, no more
than 45 days as being in an acceptable range. So, as a strength ratio, Days
in Accounts Receivable helps us see if receivables are weak. Especially,
since the current ratio relies, in this industry, so heavily on accounts
receivable as a large part of current assets.

CAN YOU HAVE TOO FEW DAYS IN RECEIVABLES? 
Well, I'd say yes. I have seen more than one print shop with 10-18 days in
receivables. Now, the way they have achieved that is to limit their credit to
not only the most credit worthy customers within the market (thus decreasing
total sales), but they also generally get right on the telephone when their
terms aren't met. Their terms are usually net 10 days. Well, what could be
wrong with that? I don't care if you are the biggest quick print shop in
town, a large industrial customer is going to take a few weeks to pay.
Jumping on the telephone trying to collect from the purchasing agent of the
local IBM plant after ten days might not be the most prudent act for the
printer who hopes to sell these customers in the future. So, not enough days
in accounts receivable can be a sign of a too restrictive credit policy.

AGING ANALYSIS
Another measurement as to the strength of accounts receivable is an AGING
ANALYSIS. This should be a standard part of every printer's monthly analysis.
This analysis, generally available on all accounts receivable software
programs, categories all open invoices into time classes based upon the
invoice date. For instance: 0-30 days; 31-60 days; 61-90 days; and 91 plus
days. By generating this analysis, either by hand or by computer, one could
come up with something like the following recent analysis for a client:

Aged Trail Balance as of August 31, 1996

Total Due:         $77,144.77   100%      Aug. 95    Nov. 94
0-30 Days:         $34,264.12    44%       62.6%       58.6%
31 - 60 Days:     $24,694.47     32%      26.0%       24.0%
61 - 90 Days:     $ 3,985.72       5%         3.0%        7.4%
91 +                   $14,200.46    18%       8.3%      10.0%

This analysis is from a company who has 27 days in accounts receivable which
is good. Notice, however, that I also tracked the percentage of total
receivables in the various categories. Notice anything? Yes, the percentage
of 91+ has popped to 18% which is high for this company. Why? A specific
account has gone into the 91+ column, but management was aware of it and it
was paid shortly thereafter. But, this is an example of how a person can have
27 days in accounts receivable and still have a problem in one or more
accounts which an aging analysis (aged trial balance of accounts receivables)
reveals. Point is that it is your percentages and ratios compared to
themselves which is just as important as comparing them to 

industry
averages.



OTHER METHODS FOR CALCULATING DAYS IN ACCOUNTS RECEIVABLE

ACCOUNTS RECEIVABLE TURNOVER: Divide Total Annual Credit Sales by the Average
Balance in Accounts Receivable to obtain an Accounts Receivable Turnover
Rate. In short, this is the number of times accounts receivable would be
fully 

turned over

 during the year. A 12 would indicate receivables were
turned over once a month or about every 30 days. A 24 would indicate about a
two week turn or some 15 days in receivables and a 6 would indicate about a
two month or 60 day supply of uncollected receivables.

AVERAGE COLLECTION PERIOD: Divide 365 by the Accounts Receivable Turnover and
you would obtain the average collection period or the average time from the
sale to the collection of cash. For instance, an accounts receivable turnover
of 9 would yield a 40.5 day collection period (365 / 9 = 40.5).

CHARGE SALES
Remember, we are dealing with Charge Sales here. A charge sales is where you
have taken a promise from the customer to pay  (account receivable) in
exchange for printing. Transactions inwhich you take cash, check or even
credit card charges in exchange for printing are NOT charge sales to you.
Many shops of a commercial nature will have a very small percentage of cash
(cash, check, credit card) sales, such as 3% or so, and could then just use
their total sales in the calculation as a practical matter.

Other shops, it appears to me, fall into a range of 80% charge and 20% cash
with the smaller and more retail shops being 60% charge and 40% cash. It's
not so important that you have a certain percentage of cash or charge sales
(although that is a good indication of what kind of business you are in), it
is just important that you know yours for the purpose of analyzing accounts
receivable.

SIMPLE CALCULATION USING THE MONTHLY METHOD
If you have $30,000 in accounts receivable, annual sales of $300,000 and a
percentage of typical charge sales of 80%, You could calculate the Days In
Accounts Receivable this way:

$300,000 x .80 = $240,000 of charge sales divided by 12 months = $20,000 per
month of charge sales. $30,000 of accounts receivable divided by $20,000 per
month of charge sales = 1.5 months x 30 calendar days = 45 days in accounts
receivable which is on the upper edge of acceptable meaning one could make
some money by paying attention to collection of receivables.
***** *****
INVENTORY TURNOVER is also a measurement of liquidity.  Image yourself in the
auto parts business. There, you could see how stale inventory or slow moving
inventory could do serious damage. It's not usually as much of importance in
the printing industry, but it is still of concern. So, let's look at
Inventory Turnover.

Generally, it is calculated by dividing the total amount of direct materials
used during the year by the average inventory level yielding an absolute
number. (Well, we should use the average inventory level or the average of
all inventories during a year, but many just use the ending inventory level
which you can get by on if the inventory doesn't fluctuate a great deal.)
 The concept is the same as in Accounts Receivable Turnover.

Example: $300,000 in sales with 25% or $75,000 in total direct materials for
the year. If the average inventory is $5,000, then $75,000 divided by $6,250
would yield 12 inventory 

turns

 or 

turnovers

 during the year would
indicate about 30 days value of inventory on hand. A 24 would mean about 15
days of inventory value and a 6 would indicate about two months or sixty
days.

What Is Right For You?
How long does it take you to order and get direct materials? Next day? Two
days? A week? Most shops I am familiar with can operate just fine on 24
inventory turns or about a two week supply. Yours might be different, but the


right

 amount will take into consideration the time to receive the materials
and the cost to you of actually placing the order.

In fact, you can use this information to make money. Say again you are the
shop in the above example, but you have $15,000 worth of inventory on hand.
Again you have $300,000 in sales and $75,000 in total direct materials for
the year. When you divide $75,000 by $15,000, you find you have 5 inventory
turns. Hey, that's more than two months supply on hand (12 months divided by
5 = 2.4 months). You have too much inventory. Now, as a famous Performance
Group participant told me once, 

Well, you come down and tell me what I've
got too much!

 Well, we can't tell by the inventory turn ratio, but we can
tell you it is too much for you don't need two months supply when it takes
you three days to get stuff.

What's generally wrong is that the inventory is not accurate, hasn't been
taken in a year, or some other such thing. (I have written about making the
taking of inventory easier many times and will do so again if needed.)  If,
however, it is accurate, then the message inventory turns is telling you is
also accurate. You've got too much stuff. Now, take it one step further. If
$15,000 is 5 turns, how much would 24 turns be? The calculation to get from
here to there takes a little though. Actually, MULTIPLY $15,000 by 5 which
gives you the original amount of direct materials used or $75,000. Now,
divide $75,000 by 24 and you get  $3,125, or the amount you should have on
hand for a two week supply. Here's where the money is: reduce your inventory
from the $15,000 to, say $4,000 and YOU PICK UP $11,000 OF CASH without
hampering your business.

Historic Note: I actually visited a shop in the Portuguese Azores back in the
70's and their paper was 

shipped

 in from Lisbon and it took them about six
months to get it from the time of order. The amount of inventory they had to
keep on hand is substantially different than yours.
***** *****
IN PERSPECTIVE
The Current Ratio (Current Assets/Current Liabilities) is the first STRENGTH
ratio I look for because it generally shows whether or not a company can pay
its current bills. Regardless of how much money a company earns, if the
owner, for instance, takes it all out and leaves the company strapped for
cash, the company is not healthy for it can not withstand adversity which is
sure to come. If, on the other hand, the owner leaves in an adequate amount
of working capital as expressed by the current ratio, then they can take the
remainder of earnings out and spend it on the crap tables in Las Vegas, which
most would consider to be a high risk investment. So, one can have a good
current ratio and be a risk taker at the same time.

But, no, the Current Ratio by itself is not enough. One can have a strong
current ratio (Current Assets/Current Liabilities) but a bunch of bad current
assets (such as bad receivables or bad inventory). One way to assure this is
not happening is to measure the DAYS OF CHARGE SALES IN ACCOUNTS RECEIVABLE
and do an AGING ANALYSIS of accounts receivable. As for inventory, check the
number of INVENTORY TURNS. If these are in line, then you have increased
confidence that the current ratio is what it says it is.

Of course, you could have bad Current Liabilities. You might not have listed
all of the bills you owe. You may not have accrued all of the taxes you owe.
And, most commonly, you haven't properly recognized the current portion of
notes payable. And, also very commonly, you haven't properly recognized
financing leases and capitalized them on the balance sheet.

So, all of these things can also affect a current ratio and I look for them
when analyzing a balance sheet. I hope you will also for they will tell you a
lot about your company.

Until next time, remember the debits are on the left and the credits are on
the right.

Happy Trails, Tom Crouser
*****
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