This chapter focuses on the ratios and formulas that can be derived primarily
from the income statement. There are several that require additional informa-
tion from the balance sheet, as well as internal information, such as employee
headcount, that may not be readily discernible from published financial state-
ments. The general intent of the analysis tools presented here is to show a com-
pany’s ability to sustain its sales, the level of asset and expense usage required to
do so, and the sustainability of its current sales and expense levels. There are also
specialized ratios that deal with such issues as sales returns, repairs and mainte-
nance, fringe benefits, interest expense, and overhead rates.
Each of the following sections describes the uses of a ratio or formula, explains
the proper method of calculation, and gives an example. Each section also dis-
cusses how each ratio or formula can be misused, skewed, or incorrectly applied.
SALES TO WORKING CAPITAL RATIO
Description: It is exceedingly important to keep the amount of cash used by an
organization at a minimum, so that its financing needs are reduced. One of the best
ways to determine changes in the overall use of cash over time is the ratio of sales
to working capital. This ratio shows the amount of cash required to maintain a cer-
tain level of sales. It is most effective when tracked on a trend line, so that man-
agement can see if there is a long-term change in the amount of cash required by
the business in order to generate the same amount of sales. For instance, if a com-
pany has elected to increase its sales to less creditworthy customers, it is likely that
they will pay more slowly than regular customers, thereby increasing the com-
pany’s investment in accounts receivable. Similarly, if the management team de-
cides to increase the speed of order fulfillment by increasing the amount of
inventory for certain items, then the inventory investment will increase. In both
cases, the ratio of working capital to sales will worsen because of specific man-
agement decisions. This ratio is also used for budgeting purposes, since budgeted
working capital levels can be compared to the historical amount of this ratio to see
if the budgeted working capital level is sufficient.
Formula: Annualized net sales are compared to working capital, which is ac-
counts receivable, plus inventory, minus accounts payable. One should not use an-
nualized gross sales in the calculation, since this would include in the sales figure
the amount of any sales that have already been returned and are therefore already
included in the inventory figure. The formula is:
Annualized net sales
———————————————————————
(Accounts receivable + Inventory – Accounts payable)
Example: The Jolt Power Supply Company has elected to reduce the amount of
inventory it carries for some of its least-ordered stock items, with the goal of in-
creasing inventory turnover from twice a year to four times a year. It achieves its
inventory goal rapidly by selling back some of its inventory to its suppliers in ex-
change for credits against future purchases. Portions of its operating results for the
first four quarters after this decision was made are shown in Table 2.1.
The ratio calculation at the end of each quarter is for annualized sales, so we
multiply each quarterly sales figure by 4 to arrive at estimated annual sales. The
accounts receivable turn over at a rate of once every 30 days, which does not
change through the term of the analysis. Inventory drops in the second quarter to
arrive at the new inventory turnover goal, while the amount of accounts payable
stays at one-half of the revenue level, reflecting a typical distributor’s gross mar-
gin of 50% throughout all four periods. The resulting ratio shows that the company
has indeed improved its ratio of working capital to sales, but at the price of some
lost sales to customers who were apparently coming to the company because of its
broad inventory selection.
Cautions: As stated in Table 2.1, using this ratio to manage a business can result
in unforeseen results, such as a drop in sales because of reduced inventory levels
or tighter customer credit controls. Also, arbitrarily lengthening the terms of ac-
counts payable in order to reduce the working capital investment will likely lead
to strained supplier relations, which may eventually result in increased supplier
prices or the use of different and less reliable suppliers.
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