Week 4 Asset Utilization Ratios

Week 4: Lecture

Asset Management Ratios

As mentioned previously, these types of ratios indicate how productive the firm's assets are if they are producing what they should. For the purposes of this course we will discuss three asset utilization ratios—Inventory Turnover, Average Collection Period, and Total Asset Turnover (see below).

Ratio Formula
Inventory Turnover COGS
Inventory
  For Amalgamated Hat Rack in 2016: 1,600,000
755,000		 = 2.11
  This indicates that Amalgamated Hat Rack “turned over,” or completely sold out and restocked, it’s inventory about two times during the year.

Important Note: Do not be surprised to see this ratio calculated with Sales in the numerator rather than COGS (it is that way in the text, for example). Many financial analysts do it that way despite the fact that it is not as accurate because the sales figure is based on sales prices which may not be directly related to the cost of the inventory.  That is why we prefer to use COGS in the numerator.

      
  Note: If the company’s inventory level changes substantially during the year then the ratio calculation above will give you misleading results. That’s because the inventory number in the denominator ($755,000) represents only the inventory on hand at the end of the year. If the inventory on hand at the beginning of the year was significantly different, say, $835,000, then the “real” inventory turnover rate is not 2.11 Instead, it would be 2.01 1,600,000
(755,000 + 835,000)/2		 = 2.01
  The more a company’s inventory changes during the year the more important it is to use “average” inventory numbers from throughout the year rather than end-of-year figures to compute the inventory turnover ratio.      
Average Collection Period (ACP) Accounts Receivable
Average Credit Sales per day
  For Amalgamated Hat Rack in 2016: 512,000
(3,200,000/365)		 = 58.4
days
 

This indicates Amalgamated Hat Rack’s credit customers are taking a little over 58 days, on average, to pay their bills.

Note: Some texts put Acct. Rec times 365 in the numerator and total credit sales in denominator.  The presentation provided above, although the same, is more logical. 

      
Total Asset Turnover (TAT) Sales
Total Assets
  For Amalgamated Hat Rack in 2016: 3,200,000
3,461,000		 = 0.92
  Each $1 of assets is producing $0.92 in sales.

Note: That’s good if the average in the industry is 0.5, bad if the average in the industry is 1.5.