Last week I wrote about how the three main financial statements of your business contain five sections as follows:
- Assets (the things you own)
- Liabilities (what you owe)
- Equity (what’s leftover for you)
(the above 3 sections are on the Balance Sheet)
- Revenues (the inflows into your business)
- Expenses (the outflows from your business)
(the above 2 sections are on your Income Statement)
To understand the story of your business month by month, year by year you need a sharper focus.
That sharper focus can begin with ratios.
Last week I wrote about liquidity ratios and profitability ratios.
To recap, liquidity ratios – the main one being your current ratio – tells you how well you are able to pay your bills as they come due.
The profitability ratios include your Gross Profit Margin, your Net Profit Margin and Return on Equity. These tell you how profitable your business is and what your return on investment is.
This week I will write about…
Activity Ratios
There are three main activity ratios:
- Average days inventory
- Average days receivable
- Average days payable
The above three ratios can be summarized in what is called your Cash Conversion Cycle.
The intent of the above ratios is to show you how quickly you sell your inventory, convert your accounts receivable to cash and the time you take to pay your bills in order to conserve cash.
First, let us look at…
Average Days Inventory
To calculate this ratio, you first take your opening inventory for the period (month or year) and add this to your closing inventory. Then divide by two.
Take this average and multiply by the days in the period (for example 30 or 31 for a month) and divide this by your Cost of Goods Sold for the same period.
The smaller the number the better. A smaller number means you are selling your inventory more quickly. A longer number of days means your cash is tied up in inventory.
The next ratio is….
Average Days Receivable
This measures the average number of days customers take to pay for your goods or services.
For example, if you give your customers terms of 30 days, and your days receivable are running at, say, 25 days, then you are doing great.
You calculate your days receivable as follows:
Opening Accounts Receivable at beginning of the period (month for instance) plus Closing Accounts Receivable at end of the period divided by two.
Now, take the average accounts receivable times the number of days in the period (30 or 31 for a month) and divide that number by your Revenue for that same period.
Even if you have a small number, which is great, it is important to review each aged account receivable.
This is because fast payers can bring the average down, hiding slow payers.
In a tough economy, you are only as successful as your clients are successful.
The other thing to keep in mind is that your accounts receivable is what your customers will want to stretch out as long as possible. Your account receivable is their accounts payable!
The best way to get your receivables paid fast is persistent, constant communication. The cliché “the squeaky wheel gets the grease” applies here.
A large bad debt could cripple your business.
Now, let us examine…
Average Days Payable
This is a measurement of how long you take to pay your supplier bills, on average.
For this Key Ratio, longer is better.
Why? Because it means you are holding onto your cash longer.
However, you will not want to jeopardize your relationships with your suppliers.
You calculate average days payable as follows:
Opening accounts payable plus closing accounts payable (for the period) divided by two.
Take the average as above times the number of days in the period and divide that by the Total Cost of Goods Sold for the period.
Now, we can summarize all three of the above ratios into one number…
Cash Conversion Cycle
Your cash conversion cycle is the number of days, on average, it takes to convert your working capital into cash.
Here is how you calculate this ratio:
You simply add your Average Days Inventory to your Average Days Receivable and then subtract your Average Days Payable.
Let us assume you take 60 days on average to sell your inventory, and 20 days on average to collect your receivables, and 40 days on average to pay your supplier bills.
Your Cash Conversion Cycle is 60 + 20 – 35 = 45 days.
Is it possible to have a negative Cash Conversion Cycle?
Yes!
Let us say you turn your inventory every 20 days and collect your accounts receivable in 15 days and take 40 days to pay your bills.
Your Cash Conversion Cycle will be: 20 + 15 – 40 = negative 5 days.
This is awesome, and the sign of an extremely healthy business.
Thanks for reading…