Using Ratios

1
Using Ratios

• This example will help show how a small business
  can use simple ratios to analyze the impact of
  future changes and the impact on key things like
  cash due to growth.

2
Company Information

• Sales
• Average A/R
• Gross Profit
• Average Inventory
• Annual Overhead

• 750,000
• 125,000
• 275,000
• 145,000
• 205,000

3
Question 1

• What is the average collection period ratio for
  this business?

4
Answer

• First we need the Receivables Turnover ratio
  (credit sales/average A/R)
• 750,000/125,000 (assuming all sales are credit)
• Receivables Turnover 6 times
• Then we divide the of days in their accounting
  period by the Receivables Turnover ratio
• 365/6 61

5
Question 2

• What if Meades average collection period
  improves by 5 days, what will be the impact on
  cash flow?
• Is there enough information to answer this
  question?
• Where would you start?

6
Answer

• The new average collection period56 days
• Now we have to work backwards their collection
  period is how quickly their customers pay them,
  so if they get paid in 56 days, their Receivables
  Turnover is 6.5 times (365/56). Now what?

7
Changes

• What 2 things could change to get this new ratio?
• Average Accounts Receivable
• Credit Sales
• Which one sounds like the best choice for an
  improvement in collection?
• I would opt for A/R we dont know anything
  about sales improving, only that people are
  paying them on a more timely basis.

8
Results

• Now we can work out some new numbers. If sales
  are constant and we have a new Receivables
  Turnover Ratio, we can arrive at the following
• Sales (750,000)/Avg. AR 6.5
• Avg. A/R 115,384.61
• On average, they have an additional 10,000 of
  cash on hand to use for the operation of the
  business!!

9
Question 3

• If sales increase by 10, what will be the
  impact on A/R?

10
Assumptions

• Lets assume that the business will maintain
  operations similar to the point before the
  increase.
• Then all that needs to be done is to determine
  the ratio of A/R to sales.

11
Results

• Sales
• Avg. A/R
• Rec. Turnover Ratio
• Sales (10 increase)
• Avg. A/R
• Rec. Turnover Ratio

• 750,000
• 125,000
• 6
• 825,000
• 137,500
• 6

12
Question 4

• If sales increase by 10, what will be the impact
  on inventory?

13
Process

• We can use the same process as before, just
  different numbers.
• A good approach would be to keep the ratio of
  inventory to sales constant, here are the results.

14
Results

• Sales
• Avg. Inventory
• Ratio Inv/Sales
• Sales (10 increase)
• Avg. Inventory
• Ratio Inv/Sales

• 750,000
• 145,000
• 0.19333333
• 825,000
• 159,500
• 0.19333333

15
Another Approach

• We can also look at keeping the inventory
  turnover ratio constant. Inventory turnover is
  Cost of Goods Sold divided by Avg. Inventory
• COGS (475,000)/Avg. Inv.(145,000)3.27586
• If sales increase 10 and we want to keep this
  ratio constant, we need to update the COGS (keep
  it at the same of sales) and then determine the
  new inventory level.

16
Results

• COGS (as of sales)
• Sales (10 increase)
• COGS
• Avg. Inventory
• Inv. Turnover ratio

• 0.63333333
• 825,000
• 522,500
• 159,500
• 3.27586