Activity Ratios - Business Finance - ثاني ثانوي

3.7 Activity Ratios Key Terms Inventory turnover Receivables turnover Fixed asset turnover Total asset turnover Link to digital lesson www.den.edu.sa Activity ratios indicate how rapidly the firm is turning its assets (for example, inventory and accounts receivable) into cash. Two activity ratios that are frequently encountered are inventory turnover (how quickly they can sell their products) and receivables turnover (the average time required to collect outstanding debt). 3.7a Inventory Turnover Inventory turnover is a measure used by accountants and managers to objectively measure the speed at which things are sold. Inventory turnover is defined as annual sales divided by average inventory: Inventory turnover Sales Average inventory Since most assets must be financed, the more rapidly the asset inventory turns over, the less financing is needed by the firm. Since Daana's 20X0 year-end inventory was SAR 1,380,000 and current inventory is SAR 1,235,000, the inventory turnover for 20X1 is: SAR 10,200,000 (SAR 1,235,000+ SAR 1,380,000) / 2 7.8 This indicates that annual sales are 7.8 times the level of inventory. Put another way, inventory turns over 7.8 times a year or about once every 1.5 months (12 months/7.8 times = 1.5 months/turnover). The turnover may be expressed in days by dividing the number of days in a year by the inventory turnover. hventory unav The speed with which the things that a firm has avallable to sell are sold Turnover in days = Number of days in a year Inventory turnover Thus, in this illustration, the firm holds an average item of inventory for almost 47 days (365/7.8=47). وزارة التعليم 2821-184 CHAPTER Analysis of Financial Statements 111

Since management can anticipate that on the average inventory will be held for 47 days. the firm will need to find financing for that period of time to carry the inventory. You Try It Omar's business started the year with SAR 2,100,000 in inventory. At the end of the period, the inventory was SAR 2,350,000. The company's sales volume during the same time was SAR 10,450,500. What is the inventory turnover for the year? What is the turnover in days? How would you interpret your calculations? Receivable wav The speed with which a firm is able to collect money that is owed 3.7b Receivables Turnover A measure used to gauge how efficiently accounts receivable are being collected is receivables turnover, which can be defined as the annual sales divided by the accounts receivable. Thus, the receivables. turnover ratio is expressed as follows: Receivables turnover Annual sales Accounts receivable For Daana's Delights, the receivables turnover is: M 112Business Finance Receivables turnover SAR 10,200,000 SAR 1,172,000 = 8.7 Note that 8.7 times a year is about every 42 days (365/8.7). You Try It Sarah's online electronics business has annual sales of SAR 1,500,000 and accounts receivable of SAR 225,000. What is the receivables turnover?

3.7c Fixed Asset and Total Asset Turnover Companies invest significantly in fixed assets to support their business operations. These fixed assets include things such as property, factories, and the equipment needed to support production. Most of these fixed assets are very expensive and investors want to know if the investment in these assets is rewarding the company with increases in sales. One way to measure this is to compare the firm's net sales to its fixed assets to gauge the company's ability to generate sales from the fixed asset investments. The fixed asset turnover ratio is defined as: Fixed asset turnover = Sales Fixed assets For Daana's, the fixed asset turnover is: Fixed at turnover An efficiency ratio that indicates how well or efficiently a business uses objects that have been purchased for long-term use to generate sales SAR 10,200,000 SAR 1,972,000 = 5.2 This result indicates that sales are 5.2 times fixed assets (land, plant, and equipment). The higher this ratio, the more sales the firm is generating from their fixed asset investments, signaling that the plant and equipment the firm is employing is yielding good results. These ratios differ by industry. Utilities, for example, must make a substantial investment in equipment to produce the output they sell, whereas retailers or service providers may need only modest amounts of fixed assets. Another measure of efficiency is to compare sales to all assets. Total asset tumover measures how assets are used to generate sales. The definition of total asset turnover is: Tomlet turmever Ratio of sales to everything that aim owns, a measure of the amount of assets that a firm has which is required to generate sales Total asset turnover Sales Total assets For Daana's, the total asset turnover is: SAR 10,200,000 SAR 9,654,000 = 1.06 This indicates the firm needs SAR 1.00 in assets for every SAR 1.06 generated in revenues. وزارة التصليد CHAPTER 3 Analysis of Financial Statements 113

P114 lyBusiness Finance ** You Try It Rasheed's technology company has sales of SAR 25,689,000, fixed assets of SAR 2.800,000, and total assets of SAR 5,000,000, Calculate the fixed asset turnover and the total asser turnover. Exercises Choose the correct answer. 1. A measure used to gauge how efficiently accounts receivable are being collected is receivables turnover. True/False 2. An inventory turnover ratio of 8.2 means that: a. inventory has turned over 8.2 times during the year, b. cash is 8.2 times annual sales. c. annual sales were 8.2 times annual average inventory. d. the company's assets are high during the year.