Turnover Ratios: Is your Company Efficient Enough to Survive?

This blog provides with the insight on the importance of Activity ratio in the stock market and its usage.

Introduction

Activity / Turnover Ratios are also known as efficiency ratios. These are the measure of a firm’s efficiency in using its resources to generating income. Optimal utilisation of the resources will result in good profits whereas, under utilisation of resources would eventually squeeze the profits. To get an insight into a company’s productivity, analysts use some key ratios to understand the management of operations in a company.

Some important Turnover Ratios

These ratios look at productivity in terms of inventory management, receivables management assets turnover in comparison to sale etc. These ratios measure the productivity and efficiency in the short-run that can ultimately affect the long-term performance. Let us look at them one-by-one.

To have more logical comparisons it is better to compare companies in similar business rather than random comparison. Let us analyse three major paint company to get an insight into their level of efficiency using these ratios.

• Asian Paints
• Berger Paints
• Kansai Nerolac paints

Inventory Turnover ratio- The inventory turnover ratio shows how many times a company have sold their inventory in a year or a particular period and have replaced them with new stock.  A higher ratio shows good inventory management and higher sales and a lower ratio suggests that the company needs to pull-up their socks and try to increase the sales. Its takes “Cost of goods sold” as a numerator and “Average inventory” as a denominator to calculate inventory turnover ratio.

Inventory Turnover Ratios = Cost of Goods Sold / Average Inventory

Analysis - Here we can observe that inventory turnover ratio for all the three companies is dropping continuously from the year 2016. that may be due to low sales or change in policies related to inventory management, and it is defiantly a worrying sign for the whole industry. If we segregate these three companies, we can see that Berger paint is the most stable as it started with a low ratio only, other than that Asian paint and Nerolac dropped more significantly. To calculate average inventory the formula is -

Previous year inventory + Current year inventory) / 2

Days in Inventory turnover- This metric provides a different view on the “Inventory turnover Ratio” as it tells you how many days it takes to replace the existing inventory. A higher number depicts that a company is taking more days to sale the stock and, a lower number means they are selling the goods fast.

Days in Inventory = 1 / Inventory Turnover Ratio * 365  or

Days in inventory = Average Inventory / Cost of Goods Sold * 365

Analysis- In this modification of inventory turnover ratio, we can see that the days it takes to sell the stocks are increasing from the starting year. By looking at this graph, we can say that Asian paint’s days in the sale of inventory have nor increased that much when we compare it with Nerolac and Berger.

Note: - “Days in inventory” and “Inventory Turnover Ratio” can be very different depending on the type of business as some businesses prefer to keep their inventory and sell them when the demand is high.

Assets Turnover Ratio- You might have heard that; “Assets are those items on a balance sheet which provide future economic benefit”. In this context, we can say that with the help of assets a company produces goods, then the company sell them and earn revenue and ultimately reach to net profit.

So, the “Assets Turnover Ratio” measure the rate of efficiency at which the assets are utilised in order to produce generate revenues. We calculate it as “net sales / average total assets” to see the degree at which the assets are utilised in a company where, a high ratio means good efficiency and a low ratio means poor efficiency.

Assets Turnover Ratio = Net sales / Average Total Assets

Analysis - From the above chart we can say that assets turnover ratio for all three companies has dropped from where they started. Above all Asian paints saw the worst drop after 2017 whereas Berger and Nerolac have also saw a decrease in their efficiency but slowly. To calculate average total assets the formula is -

Total assets of previous year + total assets of current year) / 2

Debtor’s Turnover Ratio- Sometimes businesses need to sell goods on credit to its client, due to that a “receivables” account gets created on the assets side of the balance sheet under the sub-head current assets to show for the amount the clients owe to the company.

The Debtors turnover ratio is also known as Receivables ratios; it is a financial metric that shows how efficiently a company collects its receivables from the clients. A high ratio indicates that a company is good at collecting the dues and, a low ratio shows poor collection management by the company. A bad collections policy may slow down the company’s operation and can be destructive in the long-run.

Debtor’s Turnover Ratio = Net Credit Sales /Average Accounts Receivable

Note: - Average accounts receivable is calculated same as average assets and average inventory.

Days in accounts receivable - For explanation we are taking “Receivables turnover days” which gives us a much simpler parameter to evaluate the accounts receivables management of a company.

Analysis - We can say that collections days for Asian paints and Nerolac has increased and, it is not a good sign as delay in the collection might result in bad debt also it decreases the flow of business. For Berger, the collection period has dropped from the year 2016 so, we can say that their receivables management is not good.

Conclusion

The overall efficiency of these three paint companies have decreased in inventory, asset and receivables management when compared to the starting period.