Ratio Analysis: Efficiency Ratios and Cash Flow

In this digest of Axel Tracy’s book, “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet,” we explore the two remaining efficiency ratios in the book.

They are similar to the inventory turnover ratio discussed previously. The first is the “Accounts Receivable Turnover” ratio and the second is the “Day’s Sales in Receivables” ratio.

Efficiency refers to the amount of output an organization can get from a fixed amount of input; as in how many dollars' worth of output can we get from a dollar’s worth of inputs? Accounts receivable turnover is one of the ways we measure this efficiency.

Investors, however, may not get a lot of benefit from it. Tracy advised, “This ratio is used for internal purposes for those within an organization, instead of externally from those outside. This is because it is almost impossible to garner the necessary inputs unless you have access to internal reporting.”

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What’s needed from internal reporting is the level of credit sales for a specific period; without it, the ratio cannot be calculated. This becomes obvious when the formula is shown:

“Accounts Receivable Turnover = Credit Sales / ((Accounts Receivable at Start of Period + Accounts Receivable at End of Period) / 2)”

Information for credit sales comes from internal accounting records, while accounts receivable data comes from the previous year’s balance sheet and the current year’s balance sheet.

The number for accounts receivable turnover that’s produced by the calculation tells us how many times management has turned their complete accounts receivable into cash—on average. For example, a figure of 6.5 would mean the company has converted its receivables into cash 6.5 times during the period (typically one year).

Higher turnover suggests the company is doing a good job on its collections, which is, of course, a good thing, and vice versa. But collections never occur in a vacuum and analysts should also consider the effects of economic cycles as well as booms and busts. For example, we would suspect that collections got a lot tougher for many companies during the 2008 financial crisis.

Since the value of credit sales is not publicly published, GuruFocus does not cover the accounts receivable turnover ratio. Nor does it cover day’s sales in receivables, but the information to calculate it is publicly available.

Day’s Sales in Receivables

Tracy had this to say of the ratio:

“This is one of my favorite ratios, especially when it comes to efficiency management. Why? Because it has the ability to turn accounting and financial data from the financial statements into a result that is expressed in time, that is, in days.

Days’ Sales In Receivables tells you how many days on average it takes to turn your accounts receivable balance into cash. Therefore it measures the efficiency of your collections policy and department.”

The author mentioned one other important element to the day’s sales ratio: “it has a unique advantage in relation to the previous ratio because it allows a level of cash flow planning, which aids in management decision making, that is more easily observed and understood.”

From another perspective, this ratio allows management to adjust the timing of its spending to match incoming funds.

The calculation is based on this formula:

“Days’ Sales in Receivables = ((Accounts Receivable at Start of Period + Accounts Receivable at End of Period) / 2) / (Sales Revenue / 365)”

All of the data needed for this calculation are publicly available: sales revenue from the income statement, accounts receivable from the previous and current balance sheets.

The number that emerges from the calculation tells us how many days it takes, on average, for credit sales (accounts receivable) to be turned into cash. For example, 35 means the average turn requires 35 days from the date of the credit sale to the date payment is received.

According to the author, there are four key drivers of change in the day’s sales ratio:

1. Efficiency of the company’s collection efforts.
2. A company’s credit and collections policies.
3. The overall state of the economy.
4. Effects of change in the level of credit sales.

The fourth driver refers to a situation in which credit sales increase, but all else remains the same. If this happens, the collections team may have more outstanding accounts to manage, without additional resources. On the other hand, fewer credit sales would allow accounts receivable and collections to focus on fewer accounts.

The most negative element of the day’s sales ratio was described this way by Tracy: “This main drawback is that the resulting figure is very susceptible to the particular credit policy of the business being analyzed, and the optimal credit policy cannot be accurately channeled into a single ‘time’ period as it revolves around various levels of management, marketing and service strategy.”

In a related vein, he also reported, “Then there is the fact that a simple adjustment in credit policy (and resulting level of accounts receivable) arbitrarily alters the ratio’s result when all other facets of the business have not changed at all.”

Conclusion

Two more efficiency ratios and two more ways to figure out how well cash flow is being managed. Accounts receivable turnover and day’s sales in receivables essentially measure the same thing in two different ways. Accounts receivable turnover is only available to insiders, or those who have access to the level of credit sales.

However, the absence of this ratio will be of little concern to most investors. Instead, they will turn to cash flow statements to take in the bigger picture about the direction in which cash flow overall is headed. Day’s sales in receivables will be just one of the elements in the broader cash flow picture.

Read more here:

• Ratio Analysis: Inventory Turnover
• Ratio Analysis: Times Interest Earned Ratio
• Risk Analysis: The Debt-to-Equity Ratio

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