Activity Ratios

Of the credit terms are "2/10, net 30," this aging schedule tells us that 67 percent of the receivables outstanding at December 31 are current, 19 percent are up to one month past due, 7 percent are one to two months past due, and so on. Depending on the conclusions drawn from our analysis of the aging schedule, we may want to examine more closely the company's credit and collection policies. In this example, we might be prompted to investigate the individual receivables that were billed in August and before to determine whether any should be charged off as bad debts. The receivables shown on the books are only as good as the likelihood that they will be collected. An aging of accounts receivable gives us considerably more information than does the calculation of the average collection period, because it pinpoints the trouble spots more specifically.

Payables Activity. There may be occasions when a firm wants to study its own promptness of payment to suppliers or that of a potential credit customer. In such cases, it may be desirable to obtain an aging of accounts payable, much like that just illustrated for accounts receivable. This method of analysis, combined with the less exact payable turnover (PT ratio (annual credit purchases divided by accounts payable), allows us to analyze payables in much the same manner as we analyze receivables. Also, we can compute the payable turnover in days (PTD) or average payable period as.

Payable turnover or, equivalently, Accounts payable x Days in the year Annual credit purchases where accounts payable is the ending (or perhaps, average) balance outstanding for the year and annual credit purchases are the external purchases during the year. This figure yields the average age of a firm's accounts payable.

The average payable period is valuable information in evaluating the probability that a credit applicant will pay on time. If the average age of payables is 48 days and the terms in the industry are "net 30," we know that a portion of the applicant's payables is not being paid on time. A credit check of the applicant's other suppliers will give insight into the severity of the problem.

The figure for cost of goods sold used in the numerator is for the period being studied - usually a year; the inventor)' figure used in the denominator, though a year-end figure in our example, might represent an average value. For a situation involving simple growth, an average of beginning and ending inventories for the period might be used. As is true with receivables, however, it may be necessary to compute a more sophisticated average when there is a strong seasonal element. The inventory turnover ratio tells us how many times inventory is turned over into receivables through sales during the year. This ratio, like other ratios, must be judged in relation to past and expected future ratios of the firm and in relation to ratios of similar firms, the industry average, or both.

Generally, the higher the inventor)' turnover, the more efficient the inventory management of the firm and the "fresher," more liquid, the inventory. However, sometimes a high inventory turnover indicates a hand-to-mouth existence. It therefore might actually be a symptom of maintaining too low a level of inventory and incurring frequent stockouts. Relatively low inventor)' turnover is often a sign of excessive, slow-moving, or obsolete items in inventory. Obsolete items may require substantial write-downs, which, in turn, would tend to negate the treatment of at least a portion of the inventor)' as a liquid asset. Because the inventory turnover ratio is a somewhat crude measure, we would want to investigate further any perceived inefficiency in inventory management. In this regard, it is helpful to compute the turnover of the major categories of inventory to see whether there are imbalances, which may indicate excessive investment in specific components of the inventory.

Aldine's inventory turnover of 2.02 is in marked contrast to an industry median turnover ratio of 3.3. This unfavorable comparison suggests that the company is less efficient in inventory management than is average for the industry, and that Aldine holds excessive inventor)' stock. A question also arises as to whether the inventory on the books is worth its stated value. If not, the liquidity of the firm is less than the current ratio or quick ratio alone suggests. Once we have a hint of an inventory problem, we must investigate it more specifically to determine its cause.