Operating performance ratios are usually grouped into asset management (efficiency) ratios and profitability ratios. Asset management ratios examine how well the firm's assets are being used and managed, while profitability ratios summarize earnings performance relative to sales or investment. Both of these categories attempt to measure management's abilities and the company's accomplishments.
Total asset turnover measures how well the company's assets have generated sales. Industries differ dramatically in asset turnover, so comparison to firms in similar industries is crucial. Too high a ratio relative to other firms may indicate insufficient assets for future growth and sales generation, while too low an asset turnover figure points to redundant or low productivity assets.
Whenever the level of a given asset group changes significantly during the analysis, it may help the analysis to compute the average level over the period. This can be calculated by adding the asset level at the beginning of the period to the level at the end of the period and dividing by two, or in the case of an annual figure, averaging the quarter-end periods.
Inventory turnover is similar in concept and interpretation to total asset turnover, but examines inventory. We have used cost of goods sold rather than revenues because cost of goods sold and inventory are both recorded at cost. If using published industry ratios for company comparisons, make sure that the figures are computed using the same method. Some services may use sales instead of cost of goods sold. Inventory turnover approximates the number of times inventory is used up and replenished during the year. A higher ratio indicates that inventory does not languish in warehouses or on the shelves. Like total asset turnover, inventory turnover is very industry specific. For example, supermarket chains will have a higher turnover ratio than jewelry store chains.
Receivables turnover measures the effectiveness of the firm's credit policies and helps to indicate the level of investment in receivables needed to maintain the firm's level of sales. The receivables turnover tells us how many times each period the company collects (turns into cash) its accounts receivable. The higher the turnover, the shorter the time between the typical sale and cash collection. A decreasing figure over time is a red flag.
Seasonality may affect the ratio if the period ends at a time of year when accounts receivable are normally high. Experts advocate using an average of the month-ending figures to better gauge the level over the course of the year and produce a figure more comparable to other firms. When averaging receivables, most investors will have to rely on quarter-ending figures to calculate average accounts receivable.
Average collection period converts the receivables turnover ratio into a more intuitive unit—days. The ratio indicates the average number of days receivable are outstanding before they are collected. Note that a very high number is not good and a very low number may point to a credit policy that is too restrictive, leading to lost sales opportunities. Meaningful industry comparisons and an understanding of credit sales policy of the firm are critical when examining these figures.
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