Thread: SIMPLY ACCOUNTS

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Re: SIMPLY ACCOUNTS
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Re: SIMPLY ACCOUNTS - January 12th, 2007

SALES TO WORKING CAPITAL RATIO
Description: It is exceedingly important to keep the amount of cash used by an
organization at a minimum, so that its financing needs are reduced. One of the best
ways to determine changes in the overall use of cash over time is the ratio of sales
to working capital. This ratio shows the amount of cash required to maintain a certain
level of sales. It is most effective when tracked on a trend line, so that management
can see if there is a long-term change in the amount of cash required by
the business in order to generate the same amount of sales. For instance, if a company
has elected to increase its sales to less creditworthy customers, it is likely that
they will pay more slowly than regular customers, thereby increasing the company’s
investment in accounts receivable. Similarly, if the management team decides
to increase the speed of order fulfillment by increasing the amount of
inventory for certain items, then the inventory investment will increase. In both
cases, the ratio of working capital to sales will worsen because of specific management
decisions. This ratio is also used for budgeting purposes, since budgeted
working capital levels can be compared to the historical amount of this ratio to see
if the budgeted working capital level is sufficient.
Formula: Annualized net sales are compared to working capital, which is accounts
receivable, plus inventory, minus accounts payable. One should not use annualized
gross sales in the calculation, since this would include in the sales figure
the amount of any sales that have already been returned and are therefore already
included in the inventory figure. The formula is:
Annualized net sales
———————————————————————
(Accounts receivable + Inventory – Accounts payable)
Example: The Jolt Power Supply Company has elected to reduce the amount of
inventory it carries for some of its least-ordered stock items, with the goal of increasing
inventory turnover from twice a year to four times a year. It achieves its
inventory goal rapidly by selling back some of its inventory to its suppliers in exchange
for credits against future purchases. Portions of its operating results for the
first four quarters after this decision was made are shown AS


Quarter 1 Quarter 2 Quarter 3 Quarter 4
Revenue $320,000 $310,000 $290,000 $280,000
Accounts receivable $107,000 $103,000 $97,000 $93,000
Inventory $640,000 $320,000 $320,000 $320,000
Accounts payable $53,000 $52,000 $48,000 $47,000
Total working capital $694,000 $371,000 $369,000 $366,000
Sales to working capital ratio 1:0.54 1:0.30 1:0.32 1:0.33
The ratio calculation at the end of each quarter is for annualized sales, so we
multiply each quarterly sales figure by 4 to arrive at estimated annual sales. The
accounts receivable turn over at a rate of once every 30 days, which does not
change through the term of the analysis. Inventory drops in the second quarter to
arrive at the new inventory turnover goal, while the amount of accounts payable
stays at one-half of the revenue level, reflecting a typical distributor’s gross margin
of 50% throughout all four periods. The resulting ratio shows that the company
has indeed improved its ratio of working capital to sales, but at the price of some
lost sales to customers who were apparently coming to the company because of its
broad inventory selection.
Cautions: As stated in Table, using this ratio to manage a business can result
in unforeseen results, such as a drop in sales because of reduced inventory levels
or tighter customer credit controls. Also, arbitrarily lengthening the terms of accounts
payable in order to reduce the working capital investment will likely lead
to strained supplier relations, which may eventually result in increased supplier
prices or the use of different and less reliable suppliers.
SALES TO FIXED ASSETS RATIO
Description: In some industries, a key barrier to entry is the large amount of assets
required to produce revenues. For example, the oil-refining business requires
the construction of a complete refining facility before any sales can be generated.
By using the sales to fixed assets ratio, one can see if a company is investing a
great deal of money in assets in order to generate sales. This is a particularly effective
measure when compared to the same ratio for other companies in the same
industry; that is, if another company has found a way to generate profitable sales
with a smaller asset investment, then it will be rewarded with a higher valuation.
This measure is also useful when tracked on a trend line, so that one can see if
there are any sudden jumps in asset investments that the company has made to incrementally
bring in more sales. For example, a printing facility may have
achieved 100% utilization of its printing plant, and so cannot generate more sales
without a multimillion dollar investment in new equipment. In such cases, the key
question is whether there is a reasonable expectation of generating a sufficient incremental
increase in revenues to justify the additional investment.
Formula: Divide net sales for a full year by the total amount of fixed assets.
There are several variations on this formula. One is to calculate annualized net
sales on a rolling basis, so that the last 12 months of revenue are always used. This
can be a better approach than attempting to extrapolate revenues forward for several
months, especially if future revenues are uncertain. The denominator in the
calculation, which is the amount of total fixed assets, may be used net of depreciation
or before depreciation; the most common usage is after depreciation, since
this is more indicative of the actual value of the assets. However, if accelerated
Asset Utilization Measurements / 7
depreciation is used, there may be little relationship between the amount of depreciation
recognized and the value of the fixed assets, which may lead one to use
total fixed assets prior to accumulated depreciation. Both variations on the formula
are shown here:
Annualized net sales
—————————
Total fixed assets
Annualized net sales

——————————————————————
Total fixed assets prior to accumulated depreciation
Example: The Turtle Tank Company creates tracked vehicles for a number of
military organizations. It has recently received an order from the country of Montrachet
for annual delivery of 20 tanks per year for the next eight years. The trouble
with this order is that the company’s existing capacity can only handle 10 more
tanks per year. An entire additional production line must be created in order to
manufacture the extra tanks, which will require an increase in fixed assets of $20
million. The price the company will receive for each tank is $850,000. Currently,
it produces 70 tanks per year, and has fixed assets of $40 million. Based on these
numbers, its net sales to fixed assets ratio will change as shown in Table 2.2.
The Turtle Tank Company is a publicly held company, so its management is
concerned that the much lower ratio that would be caused by the new investment
would not compare favorably to the same ratio for its competitors. This might
cause investors to think that the company is poorly managed, resulting in a sell-off
of its stock. An alternative solution for the situation is for the managers to ignore
the short-term impact of the ratio and instead to focus on the key issue, which is
whether there will be enough additional business in the future to justify the additional
investment.
Cautions: The sales to fixed assets ratio should not be used at a consolidated
level for companies that include many types of businesses, since it is quite possible
that only a few businesses within the entity are asset-intensive. For this reason,
it is better to calculate the measure for individual businesses or product
lines. The ratio can also be misleading if a company does not have sufficient
funds to purchase new assets, in which case it may appear to have a small asset
base due to the large amount of offsetting depreciation expense that has accumulated
over time.
8 / Business Ratios and Formulas
Table ===
If No Change If Invest in New Line
Annual sales $68,000,000 $76,500,000
Total fixed assets $40,000,000 $60,000,000
Sales to fixed asset ratio 1.7:1 1.3:1

Last edited by bonddonraj; January 12th, 2007 at 01:47 AM..
   
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