In this session we shall start to look at Use of Resources Ratios. We shall consider what they try to measure and then go through the following ratios:
- Inventory turnover
- The Working Capital Cycle which combines the following
- The Inventory Holding Period (days) ratio;
- The Trade Receivables Collection Period (days) ratio; and
- The Trade Payables Payment Period (days) ratio
Use of Resources Ratios
Use of resources ratios provide information on how efficiently a business uses its assets. In this session we shall focus on those relating to a business’ working capital and in the next session we shall look at those relating to other assets.
Working Capital
Working capital is the net current assets of a business; that is, its current assets less its current liabilities.
Good working capital management is important for any business. Too little working capital can lead to cash flow problems and poor liquidity, whilst too much working capital can hide inefficiencies and indicate poor management.
Inventory Turnover
Inventory turnover calculates how many times a business uses up or sells its inventory in a year. It is a measure of how well a business manages its inventories and is presented as a number of times.
The formula is shown below.
Quick questions
1. A business’ cost of sales are £35,569,882 and it holds inventories as follows: raw materials costing £1,008,973, work-in-progress of £501,619 and finished goods of £2,707,345. Calculate the inventory turnover to two decimal places
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Total inventory is 1,008,973+501,619+2,707,345 = £4,217,937
Inventory turnover is 35,569,882/4,217,937 = 8.43 times
2. Last year, a business made sales of £840,000. Its gross profit percentage was 56%. If its inventory turnover was 4.5 times calculate the value of its inventory to the nearest pound
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- Gross profit for the year was 840,000 x 56% = £470,400
- Cost of sales for the year was therefore 840,000 – 470,400 = £369,600
- Inventory was 369,600/4.5 = £82,133
Illustration
A company’s financial statements are shown below.
To calculate Inventory Turnover we will use the Cost of Sales (£8,610) from the Statement of Profit or Loss and the Inventory (£1,190) from the Statement of Financial Position.
Inventory Turnover: 8,610/1,190 = 7.24 times
Evaluating Inventory Turnover
Generally, an inventory turnover that is higher than its comparator is good as it means that the business is selling or using its inventories more quickly and has less money tied up in this asset. Remember that it costs money to hold inventory, a suitable holding space is required and it costs money to raise the funds required to buy them.
There are circumstances however where a high inventory turnover could indicate that the business is holding too little inventory and may lose sales, or incur delays in its production processes, due to stock-outs.
The Working Capital Cycle
The working capital cycle attempts to calculate the amount of time that cash is tied up in buying and selling goods. A business might for example, purchase an item of inventory which is then held until it is sold. The business might take a period of credit from its supplier but also might have to offer its customer a period of credit before it pays the business. The working capital cycle is therefore based on:
- The amount of time the inventory is held by the business
- The amount of time the customer takes before paying the business
- The amount of time the business takes before paying its supplier
In order to calculate the working capital cycle we must calculate and then combine three other separate ratios.
The formulas used to calculate the separate ratios are shown below.
All of these ratios are presented as a number of days and whilst these are often shown to the nearest day, they can also be shown to a number of decimal places.
Quick questions
1. Last year a business made sales of £950,000 and a gross profit of £390,000. Its year-end inventory was £175,000. Calculate the inventory holding period to one decimal place
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Cost of sales is 950,000-390,000 = £560,000
Inventory holding period (days) is 175,000/560,000 x 365 = 114.1 days
2. A business has an inventory holding period of 62 days. If the business’ cost of sales is £730,000 calculate the value of its inventory
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- Inventory holding period = Inventory/Cost of sales x 365
- If we rearrange the above formula:
- Inventory = Inventory holding period x Cost of sales /365
- Inventory = 62 x 730,000 /365 = £124,000
3. A business’ inventory cost £510,000. If the business has an inventory holding period of 25 days, calculate the value of its cost of sales
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- Inventory holding period = Inventory/Cost of sales x 365
- If we rearrange the formula
- Cost of sales = Inventory/Inventory holding period x 354
- Cost of sales = 510,000/25 x 365 = £7,446,000
4. A business made sales last year of £335,241. Its trade receivables were £83,446. Calculate the business’ trade receivables collection period (days) to two decimal places.
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Trade receivables collection period is 83,446/335,241 x 365 = 90.85 days
5. A business’ trade receivables collection period is 60 days. If its sales are £274,200 calculate the value of its trade receivables to the nearest pound
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- Trade receivables collection period = Trade receivables/Sales x 365
- If we rearrange the formula
- Trade receivables = Trade receivables collection period x Sales / 365
- Trade receivables = 60 x 274,200 /365 = £45,074
6. A business’ trade payables are £312,046 and its cost of sales are £2,388,481. Calculate the trade payables payment period (days) to one decimal place.
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Trade payables payment period is 312,046/2,388,481 x 365 = 47.7 days
7. A business’ trade payables payment period is 38 days and its trade payables are £71,392. Calculate the cost of sales to the nearest pound
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- Trade payables payment period = Trade payables/Cost of sales x 365
- If we rearrange the formula:
- Cost of sales = Trade payables/Trade payables payment period x 365
- Cost of sales = 71,392/38 x 365 = £685,739
8. A business’ ratios are as follows:
Trade payables payment period: 88.2 days
Inventory holding period: 52.4 days
Trade receivables payment period: 40.9 days
Calculate the working capital cycle
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Working capital cycle is 52.4 + 40.9 – 88.2 = 5.1 days
9. A business’ trade payables payment period is 34 days. Its inventory holding period is 62 days and its working capital cycle is 49 days.
What is the business’ trade receivables collection period?
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The trade receivables collection period is 49 – 62 + 34 = 21 days
Illustration
We will use the same example as used above for calculating Inventory Turnover
The Inventory Holding Period (days) ratio uses the Cost of Sales from the Statement of Profit or Loss and Inventory from the Statement of Financial Position.
Inventory Holding Period (days): 1,190/8,610 x 365 = 50.45 days
The Trade Receivables Collection Period (days) ratio uses Revenue from the Statement of Profit or Loss and Trade Receivables from the Statement of Financial Position.
Trade Receivables Collection Period (days): 1,380/15,030 x 365 = 33.51 days
The Trade Payables Payment Period (days) ratio uses Cost of Sales from the Statement of Profit or Loss and the Trade Payables from the Statement of Financial Position.
Trade Payables Payment Period (days): 1,260/8,610 = 53.41 days
The Working Capital Cycle can now be calculated using the above ratios.
Working Capital Cycle: 50.45 + 33.51 – 53.41 = 30.55 days
Evaluating the ratios
Negative working capital cycles
It is possible for some types of businesses to have a negative working capital cycle. A supermarket, for example, is likely to have a short-inventory holding period (as most of inventories will be sold within a few days), its trade receivables collection period is almost non-existent (since its customers pay for their goods at the point of sale) but its trade payables payment period might be relatively long (as supermarkets are often in a powerful position from which to negotiate payment terms with suppliers).
Working Capital Cycle: reasons for change
The working capital cycle will be affected by any changes that affect its constituent ratios. Examples of reasons why these may change are shown below.
Formulae variations
It is quite common for the above ratios for inventory holding period, trade receivables collection period and trade payables payment period to be calculated using slightly different formulae.
For example, some accountants will use an average of the inventories, trade receivables and trade payables at the start and end of the year rather than use the year-end figures. This is done in order to reduce the risk that short-term fluctuations in the year-end figures will affect the ratios.
Other variations would include using sales made on credit rather than total sales when calculate the trade receivables collection period (thought this information is generally unavailable to external stakeholders) and using purchases rather than cost of sales when calculating the trade payables payment period.
The ratios covered above are however, widely used and are consistent with those examined by the AAT.
Question 1
A company’s statement of profit or loss and statement of financial position are shown below.
a) Calculate the working capital cycle for both years to one decimal place
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- In order to calculate the working capital cycle the inventory holding period, the trade receivables collection period and trade payables payment period must be calculated:
- Y/E 31/12/20 Inventory holding period: 55,989/370,333 x 365 = 55.2 days
- Y/E 31/12/20 Trade receivables collection period: 71,919/588,488 x 365 = 44.6 days
- Y/E 31/12/20 Trade payables payment period: 58,967/370,333 x 365 = 58.1 days
- Y/E 31/12/20 Working capital cycle: 55.2 + 44.6 – 58.1 = 41.7 days
- Y/E 31/12/19 Inventory holding period: 50,064/340,707 x 365 = 53.6 days
- Y/E 31/12/19 Trade receivables collection period: 65,451/525,120 x 365 = 45.5 days
- Y/E 31/12/19 Trade payables payment period: 63,592/340,707 x 365 = 68.1 days
- Y/E 31/12/19 Working capital cycle: 53.6 + 45.5 – 68.1 = 31.0 days
b) By how many days have the following ratios improved or worsened from 2019 to 2020 (calculate to one decimal place)
The inventory holding period (days)
The trade receivables collection period (days)
The trade payables payment period (days)
The working capital cycle (days)
- The inventory holding period has worsened by 1.6 days
- The trade receivables collection period has improved by 0.9 days
- The trade payables payment period has worsened by 10.0 days
- The working capital cycle has worsened by 10.7 days
