Accounting Business Reporting for Decision Making

338 Accounting: Business Reporting for Decision Making

Days debtors:

Average trade debtors

×365 days=x days

Sales revenue

It is common to calculate the number of times per annum that the inventory (times inventory turnover)

and trade debtors (times debtors turnover) are turned over, rather than the number of days this occurs.

The calculations are as follows.

Times inventory turnover:

Cost of sales

=x times

Average trade debtors

Times debtors turnover:

Sales revenue

=x times

Average trade debtors

The higher the times turnover ratios, the more efficient an entity would appear to be in converting

inventory and accounts receivable to cash. It should be noted that dividing the times inventory turnover

and times debtors turnover into the number of days per annum (365) will yield the days inventory ratio

and days debtors ratio respectively. For the purpose of our analysis, we will refer to the turnover in days

rather than times.

It is not possible to prescribe what an appropriate days inventory ratio is, as it will vary according

to the type of inventory being sold. For example, a supermarket would have a significantly faster

inventory turnover than an exclusive jewellery store. Remember, however, that a supermarket’s gross

margin would be significantly lower than that of the jewellery store. Similarly, the appropriateness of

the days debtor turnover depends on the credit terms offered by the entity. Accounts receivable arise

as a result of credit sales. Note that sales revenue from both cash and credit sales is used in the ratio

calculation, as entities do not disclose the cash and credit components of sales. It would be expected

that an entity offering its customers 30-day settlement terms would have a longer days debtors com-

pared with an entity offering credit terms of only ten days. A 30-day settlement term means that the

customer is expected to pay within 30 days of the end of the purchase month. If purchasing goods on

the first day of the month, the customer effectively receives 60 days’ credit. As an arbitrary rule of

thumb, the days debtors is expected to be around 1.3 times the settlement terms offered by the entity.

When analysing an entity’s efficiency in managing its debtors and inventory, concerns would be raised

if the ratios showed an upward trend.

We can consider the days inventory and days debtors turnovers in conjunction to reflect the entity’s

activity cycle (also referred to as the operating cycle). If an entity sells only on credit terms, then

summing the days inventory and days debtors will reflect the average period of time it takes to convert

inventory into cash (the activity cycle). As inventory can be purchased on credit terms, there is often a

delay between receiving the inventory and paying for the inventory (this is referred to as days creditors).

This is why the activity cycle is longer than the cash cycle.

A period of time elapses between an entity paying for the inventory, selling the inventory, and

receiving cash for the inventory. This period is the cash cycle. During this time, the entity is effectively

financing the investment in inventory and incurring negative cash flows. Suppose that an entity’s days

inventory is 45 days, with days debtors of 55 days and days creditors of 25 days. Its activity cycle (illus-

trative example 8.1) and cash cycle are 100 days and 75 days, respectively. The length of the activity

and cash cycle will have a significant impact on the entity’s liquidity position. Given that the entity has

to finance the investment in inventory and debtors, the shorter the activity cycle, the better the entity’s

efficiency and liquidity.