The Power Of Inventory Turnover and Days Sales Outstanding Ratios

To get basic answer to the question “Is management really doing its job“ is by assessing if it done with its roles. Two of management’s main roles are to convert company’s products into revenue [means: moving its inventory into sales], and converting the sales [revenue] into cash to the shareholders’s pocket. Two ways to tell if management is doing its job is by making use the “InventoryTurnover Ratio” and “Days Sales Outstanding (DSO) Ratio”.

Inventory Turnover

To calculate: Cost of Goods Sold/Inventory = Inventory Turnover

Purpose: The speed with which a company can move its inventory indicates how popular its merchandise is; how effective its sales force is; and how well managed its assets are. Rising inventory turnover is a sign of a healthy company.

Consider $34 billion Intel, the world’s leading maker of micro-processing chips for personal computers. Intel increased the number of times its inventory turns over in a year from 3.9 in 1995 to seven times just two years later.

Based on net sales of $560 million and inventory of $98 million, LieDharma’s inventory turnover ratio is 3.6. A related ratio that some companies use is called the age of inventory ratio. This one takes the inventory turnover rate and divides it into 365 days. For LieDharma company, we would take its turnover of 3.6 and divide that into 365. This means that the company’s inventory is generally held for 101 days before sale.

The typical American company in 1997 had a long-term debt-to-capital ratio of about 42 percent. That represents a major improvement. In 1995, the average ratio stood at 58 percent; in 1991, it was a whopping 69 percent.

Companies in highly cyclical industries must analyze financial ratios at least once a month. Those that don’t, risk comparing their performance in traditionally weak months with their performance during high volume periods.

Days Sales Outstanding (DSO)

To calculate: [Accounts Receivable/[Net Sales/365] = Days Sales Outstanding[DSO]

Purpose: Managers who want to know how quickly their customers are paying their bills rely on the DSO. A rising DSO ratio which means a slowdown in repayments signals potential pressure on a company’s cash flow. For instance, LieDharma’s accounts receivable stand at $91 million. Its sales per day [$560,000,000/365] are $1,534,250. That means its DSO is 59.3 days. That’s slightly more than the 52.2 days it took its customers to pay their bills last year.

On the other side of the ledger, there is a days payable ratio, which shows how long it takes a company to pay its vendors. It is calculated by taking your company’s accounts payable, and dividing that by the cost of goods sold per day [Accounts Payable/(Cost of Goods Sold/365)]. This ratio is harder to analyze, though, since most companies like to wait as long as possible to pay their own bills. Why give up your cash until you absolutely have to?

It is more than make sense that the inventory turnover and days sales outstanding ratios are really the best [and most powerful] ratios in measuring whether the company[management] is doing its jobs. Why do companies make products if they cannot convert theirs into revenue? And; what is revenue for if it is not converted into cash. Most likely that shareholders won’t be happy if management tell about its achievement on making revenue without telling of how much sales will be paid out of the revenue to the shareholders. Shareholders expect cash in payment as a return on their investment, don’t they?

Source:

http://accounting-financial-tax.com/2009/02/the-power-of-inventory-turnover-and-days-sales-outstanding-ratios/