Chapter 5 Turnover Ratios PDF

Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING CHAPTER 5 TURNOVER RATIOS Learning Objectives: Understand the definition of Turnover ratios. Explain the definition of solvency ratios. Understand the overall profitability ra...

Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING CHAPTER 5 TURNOVER RATIOS Learning Objectives: Understand the definition of Turnover ratios. Explain the definition of solvency ratios. Understand the overall profitability ratio. Introduction Turnover Ratios may be also termed as Efficiency Ratios or Performance Ratios or Activity Ratios. Turnover Ratios highlight the different aspect of financial statement to satisfy the requirements of different parties interested in the business. It also indicates the effectiveness with which different assets are vitalized in a business. Turnover means the number of times assets are converted or turned over into sales. The activity ratios indicate the rate at which different assets are turned over. Depending upon the purpose, the following activities or turnover ratios can be calculated: 1. Inventory Ratio or Stock Turnover Ratio (Stock Velocity) 2. Debtor's Turnover Ratio or Receivable Turnover Ratio (Debtor's Velocity) 2 A. Debtor's Collection Period Ratio 3. Creditor's Turnover Ratio or Payable Turnover Ratio (Creditor's Velocity) 3 A. Debt Payment Period Ratio 4. Working Capital Turnover Ratio 5. Fixed Assets Turnover Ratio 6. Capital Turnover Ratio. Page 1  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING (1) Stock Turnover Ratio- This ratio is also called as Inventory Ratio or Stock Velocity Ratio. Inventory means stock of raw materials, working in progress and finished goods. This ratio is used to measure whether the investment in stock in trade is effectively utilized or not. It reveals the relationship between sales and cost of goods sold or average inventory at cost price or average inventory at selling price. Stock Turnover Ratio indicates the number of times the stock has been turned over in business during a particular period. While using this ratio, care must be taken regarding season and condition. Price trend, supply condition etc. In order to compute this ratio, the following formula is used: Page 2  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Advantages (1) This ratio indicates whether investment in stock in trade is efficiently used or not. (2) This ratio is widely used as a measure of investment in stock is within proper limit or not. (3) This ratio highlights the operational efficiency of the business concern. (4) This ratio is helpful in evaluating the stock utilization. (5) It measures the relationship between the sales and the stock in trade. (6) This ratio indicates the number of times the inventories have been turned over in business during a particular period. (2) Debtor's Turnover Ratio Debtor's Turnover Ratio is also termed as Receivable Turnover Ratio or Debtor's Velocity. Receivables and Debtors represent the uncollected portion of credit sales. Debtor's Velocity indicates the number of times the receivables are turned over in business during a particular period. In other words, it represents how quickly the debtors are converted into cash. It is used to measure the liquidity position of a concern. This ratio establishes the relationship between receivables and sales. Two kinds of ratios can be used to judge a firm's liquidity position on the basis of efficiency of credit collection and credit policy. They are (A) Debtor's Turnover Ratio and (B) Debt Collection Period. These ratios may be computed as: Page 3  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING (3) Creditor's Turnover Ratio Creditor's Turnover Ratio is also called as Payable Turnover Ratio or Creditor's Velocity. The credit purchases are recorded in the accounts of the buying companies as Creditors to Accounts Payable. The Term Accounts Payable or Trade Creditors include sundry creditors and bills payable. This ratio establishes the relationship between the net credit purchases and the average trade creditors. Creditor's velocity ratio indicates the number of times with which the payment is made to the supplier in respect of credit purchases. Two kinds of ratios can be used for measuring the efficiency of payable of a business concern relating to credit purchases. They are: (1) Creditor's Turnover Ratio (2) Creditor's Payment Period or Average Payment Period. The ratios can be calculated by the following formulas: Page 4  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING (4) Working Capital Turnover Ratio This ratio highlights the effective utilization of working capital with regard to sales. This ratio represent the firm's liquidity position. It establishes relationship between cost of sales and networking capital. This ratio is calculated as follows- Significance: It is an index to know whether the working capital has been effectively utilized or not in making sales. A higher working capital turnover ratio indicates efficient utilization of working capital, i.e., a firm can repay its fixed liabilities out of its working capital. Also, a lower working capital turnover ratio shows that the firm has to face the shortage of working capital to meet its day-to-day business activities unsatisfactorily. Page 5 Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Page 6  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING IV. SOLVENCY RATIOS The term 'Solvency' generally refers to the capacity of the business to meet its short-term and long-term obligations. Short-term obligations include creditors, bank loans and bills payable etc. Long-term obligations consist of debenture, long-term loans Page 7  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING and long-term creditors etc. Solvency Ratio indicates the sound financial position of a concern to carry on its business smoothly and meet its all obligations. Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency of the concern have already been explained. Now under this part of the chapter only the long-term solvency ratios are dealt with. Some of the important ratios which are given below in order to determine the solvency of the concern: (1) Debt - Equity Ratio (2) Proprietary Ratio (3) Capital Gearing Ratio (4) Debt Service Ratio or Interest Coverage Ratio (1) Debt Equity Ratio This ratio also termed as External - Internal Equity Ratio. This ratio is calculated to ascertain the firm's obligations to creditors in relation to funds invested by the owners. The ideal Debt Equity Ratio is 1: 1. This ratio also indicates all external liabilities to owner recorded claims. It may be calculated as The term External Equities refers to total outside liabilities and the term Internal Equities refers to all claims of preference shareholders and equity shareholders' and reserve and surpluses. Page 8  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING The term Total Long-Term Debt refers to outside debt including debenture and long- term loans raised from banks. (2) Proprietary Ratio Proprietary Ratio is also known as Capital Ratio or Net Worth to Total Asset Ratio. This is one of the variant of Debt-Equity Ratio. The term proprietary fund is called Net Worth. This ratio shows the relationship between shareholders' fund and total assets. It may be calculated as: Significance: This ratio used to determine the financial stability of the concern in general. Proprietary Ratio indicates the share of owners in the total assets of the company. It serves as an indicator to the creditors who can find out the proportion of shareholders' funds in the total assets employed in the business. A higher proprietary ratio indicates relatively little secure position in the event of solvency of a concern. A lower ratio indicates greater risk to the creditors. A ratio below 0.5 is alarming for the creditors. Page 9  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING (3) Capital Gearing Ratio This ratio also called as Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The term capital gearing refers to describe the relationship between fixed interest and/or fixed dividend bearing securities and the equity shareholders' fund. It can be calculated as shown below: A high capital gearing ratio indicates a company is having large funds bearing fixed interest and/or fixed dividend as compared to equity share capital. A low capital gearing ratio represents preference share capital and other fixed interest bearing loans are less than equity share capital. Page 10  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING V. OVERALL PROFITABILITY RATIO This ratio used to measure the overall profitability of a firm on the extent of operating efficiency it enjoys. This ratio establishes the relationship between profitability on sales and the profitability on investment turnover. Overall all Profitability Ratio may be calculated in the following ways: Page 11 Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Page 12 Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Page 13 Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Page 14 Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Page 15 Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Page 16  Module PSFM08 MANAGERIAL ACOUNTING WITH FINANCIAL ANALYSIS AND REPORTING Reference: Managerial Accounting by Mrs. Kanchan Rajput (IAME-Bangalore) Lecture Notes Compilation by Dean Rene Boy R. Bacay, CPA, CrFA, CMC, MBA, FRIAcc For further discussion please refer to the link provided: Turnover Ratios- https://www.youtube.com/watch?v=oIN86FQGmg4 Solvency Ratios- https://www.youtube.com/watch?v=Vssx5ugLsEM Overall Profitability Ratio- https://www.youtube.com/watch?v=ROqkmlVuXKU Page 17