Corporate Finance

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Corporate Finance

Sales/Receivables
Computation: Net sales divided by trade receivables.
This ratio measures the number of times trade receivables turn over during the year. The higher the turn-
over of receivables, the shorter the time elapsed between sales and cash collection. Obviously, a firm should
try to squeeze the lag between sales and cash collection. If the ratio is less than the industry average, quality
of receivables should be examined. When sales are seasonal, as in the air cooler industry for instance, it may
be inappropriate to take the figure for receivables on one date as the figure may not be representative of the
pattern during the entire year.

Days’ Receivables
Computation: Number of days in a year divided by sales/receivables ratio

=

Sales / sReceivable ratio

365

The figure expresses the average time in days that receivables are outstanding. Generally, the longer the
time, the greater is the possibility of default. A comparison between the day’s receivables ratio and the credit
period offered by the company to customers will throw light on the efficiency of the collection process. As
pointed out earlier, the ratio should not be calculated mechanically.

Cost of Sales/Inventory
Computation: Cost of sales divided by average inventory held.
This ratio measures the number of times inventory is turned over during the year. A higher ratio indicates
better liquidity. A low inventory turnover ratio indicates poor liquidity and possible overstocking. It is to be
noted that taking the value of inventory on one date may be inappropriate as the figure may not be representative
of inventory held during the period at various points in time. When the inventory figure is small (the
denominator), the ratio will be high leading to wrong conclusions.

Days’ Inventory
Computation: No. of days in a year divided by (cost of sales/inventory) ratio.
It measures the period of time for which the items are in inventory. It is expressed in days.

Cost of Sales/Payables
Computation: Cost of sales divided by trade payables.
It measures the number of times payables turned over during the year. The higher the ratio, the shorter is
the time between purchase and payment. Conversely, the smaller the ratio, the longer is the time between
purchase and payment. It could be either because the firm is enjoying good credit terms or deliberately
extending the credit period. As usual, the problem of seasonal fluctuations (of payables) is present in this
ratio also.

Days’ Payables
Computation: No. of days in one year divided by (Cost of sales : Payables) ratio.

(Cost of sales / Payables)

365

Meaning: It measures the average length of time for which average payables (debt) is outstanding.