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Activity Ratio
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These ratios measure the speed (in terms of days or number of times per year) current assets and liabilities are converted into cash. Activity ratios are, therefore, also a measure of a firm's liquidity.
There are two good reasons for selling stock as quickly as possible:
- There are costs involved in keeping stock on hand e.g. storage costs, insurance costs and the cost of the funds tied up in capital.
- The only way to get the gross profit connected to stock is to sell it.
Stock Turnover Ratio
The speed at which stock is sold is measured by the stock turnover ratio.
Stock turnover ratio = cost of goods sold ÷ stock
= R38 000 000 ÷ R12 000 000
= 3.17 times per year
This means that Jimco managed to sell the average amount of stock 3.17 times per year.
Industry average 2.9 times.
Stock Turnover in Days
It is customary to express stock turnover in days. This is done by dividing 365 by the stock turnover ratio just calculated.
Stock turnover in days = 365 ÷ 3.17
= Therefore, it takes 115 days, on average, to sell Jimco’s stock.
Cross sectional or time series analysis is needed to judge this figure. Stock turnovers vary widely over different industries e.g. greengrocers vs. jewellers.
Debtor’s Collection Ratio
Similarly, to stock, the quicker debtors are collected, the better for the company.
= credit sales ÷ debtors
= R51 000 000 ÷ R10 000 000
= 5.1 times
This means that Jimco, on average, collects its outstanding short-term debt 5,1 times per year. It is more customary to express this ratio in days per year.
Debtor’s Collection Period in Days
= 365 ÷ 5.1
= 71.57 days
Jimco takes, on average, 71.57 days to collect its outstanding short-term debt (debtors). Cross sectional or time series analysis is needed to judge this figure. If Jimco extended credit terms of 30 days to its customers, a collection period of 71.57 days would be reason for concern.
The speed with which the company pays its creditors is measured by the following ratio. The object here is to pay slower rather than quicker, but to take care not to jeopardise the relationship with the suppliers.
Creditors Payment Ratio
= credit purchases ÷ creditors
= R38 000 000 ÷ R3 000 000
= 12.67 times
Once again, it is more customary to express this ratio in days:
Creditors’ Payment Period
= 365 ÷ 12.67
= 28.81 days
Jimco takes, on average, 28.81 days to pay its creditors. Cross sectional or time series analysis is needed to judge this figure. If Jimco received credit terms of 30 days from its suppliers, a payment period of 28.81 days may indicate that they have no difficulty in meeting creditor payments on time.
Click here to watch a video and double check your understanding of the concept of stock turnover days.
Click here to watch a video and double check your understanding of the concept of debtors and creditors day.