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Using Ratios

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. Sales Average A/R Gross Profit Average Inventory Annual Overhead. 750,000 125,000 275,000 145,000 205,000.

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Using Ratios

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  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. Sales Average A/R Gross Profit Average Inventory Annual Overhead 750,000 125,000 275,000 145,000 205,000 Company Information

  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 Meade’s 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 period=56 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 don’t 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 • Let’s 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. 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 Results

  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. 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 Results

  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. COGS (as % of sales): Sales (10% increase): COGS: Avg. Inventory: Inv. Turnover ratio: 0.63333333 825,000 522,500 159,500 3.27586 Results

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