Last time I wrote about the accounts receivable to accounts payable and the debt to equity ratios, key ratios that tell you whether you have enough money coming in to pay your bills. This month I'll cover the "turns" ratios.

Inventory turns

Inventory turns measure how efficiently the company uses its inventory. The turns are calculated by on annual costs. Calculate this ratio by using both the income statement and the balance sheet. It is calculated: Annualized Cost of Goods Sold/Inventory.

To annualize the cost of goods sold, use the year to date figures on your income statement. For example, if you have total costs of good sold for a quarter, then you multiply this figure by four to get the estimated annual cost of goods sold.

There usually is a seasonal nature to the annualization, i.e. in six months you may have earned 75% of the revenues for the year rather than 50%. However, on a monthly basis, assuming no seasonal qualifiers is usually appropriate. Look at the year-end figure and compare it to the monthly figure. If they are close, the assuming no seasonal nature would be acceptable.

Inventory turns should be between nine and 13 times per year. If it is greater than 24, then the company may be running to the parts house too frequently (and increasing unapplied labor and other expenses). If it is under six then the company is probably keeping too much inventory on hand. For residential companies I like to see the ratio around 12 times per year.

If these figures are out of line then it is also possible that the inventory figure is overstated (when was the last time physical inventory was taken?) or the company has parts are unusable. In either of these cases, the unusable inventory should be written off or a physical inventory be taken to determine the true inventory level.

Inventory days

This financial ratio measures how long an average piece of inventory stays in the shop before it is used. You calculate this ratio from the inventory turn number. It is calculated: Inventory Turns/365.

For residential companies the result should be under 60 days. Commercial companies can stand 60 days depending on the size and duration of the projects in house. If you are a new construction company the inventory days can be as low as 10 without problems. If the inventory days are less than 10, then you are probably running to the parts house too much or are very good at practicing just-in-time inventory control.

Receivable turns

This figure measures how efficiently the company keeps track of its receivables. the turns are calculated on annualized sales. Calculate this ratio by using both the income statement and the balance sheet. It is calculated: Annualized Sales/Annualized Receivables.

To annualize sales use the year-to-date figures. For example, if you have total sales for the quarter then you multiply this figure by four to get the estimated annual sales. This figure should be six or greater. Anything less means that the company has a receivables problem. You must address this issue and work towards getting receivables current within 45 to 60 days.

Receivable days

The receivable days measures how efficiently the company collects its receivables. The days are calculated from the receivable turns figure. It is calculated: Receivable Turns/365.

This figure should be less than 60 days and preferably lower than 45. If it is larger, then see the explanation for receivable turns. If your company does mainly C.O.D. work and your receivable days are greater than 30, you have a collection problem.

NOTE: When calculating inventory And receivable turns you must factor in the time of the year. It might be that the company is gearing up for its busy season. The best way to calculate these two ratios is by using the year-end statements. This gives you the truest picture. However, if you don't have a year-end statement, do them on a monthly basis. The inventory and receivable days should reflect the time of the year to some degree (i.e., there will be more inventory at the state of a busy season and more receivables at the end of the busy season).

The inventory days should be less than the receivable days. If it is not, than you may have an inventory problem.

Copyright 2000, Ruth King. All rights reserved. Ruth King's American Contractor Exchange

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