90 Part 2 Fundamental Concepts in Financial Management
high, which will depress its pro! ts. On the other hand, if its assets are too low, prof-
itable sales will be lost. So Allied must strike a balance between too many and too
few assets, and the asset management ratios will help it strike this proper balance.4-3a Inventory Turnover Ratio
“Turnover ratios” divide sales by some asset: Sales/Various assets. As the name
implies, these ratios show how many times the particular asset is “turned over”
during the year. Here is the inventory turnover ratio:Inventory turnover ratio! __________Sales
Inventories! $3,000______
$615
! 4.9"Industry average! 10.9"As a rough approximation, each item of Allied’s inventory is sold and restocked,
or “turned over,” 4.9 times per year. Turnover is a term that originated many years
ago with the old Yankee peddler who would load up his wagon with pots and
pans, then go off on his route to peddle his wares. The merchandise was called
working capital because it was what he actually sold, or “turned over,” to produce
his pro! ts, whereas his “turnover” was the number of trips he took each year.
Annual sales divided by inventory equaled turnover, or trips per year. If he made
10 trips per year, stocked 100 pots and pans, and made a gross pro! t of $5 per item,
his annual gross pro! t was (100)($5)(10)! $5,000. If he went faster and made
20 trips per year, his gross pro! t doubled, other things held constant. So his turn-
over directly affected his pro! ts.
Allied’s inventory turnover of 4.9 is much lower than the industry average of
10.9. This suggests that it is holding too much inventory. Excess inventory is, of
course, unproductive and represents an investment with a low or zero rate of
return. Allied’s low inventory turnover ratio also makes us question the current
ratio. With such a low turnover, the! rm may be holding obsolete goods that are
not worth their stated value.^3
Note that sales occur over the entire year, whereas the inventory! gure is for one
point in time. For this reason, it might be better to use an average inventory mea-
sure.^4 If the business is highly seasonal or if there has been a strong upward or down-
ward sales trend during the year, it is especially useful to make an adjustment. Al-
lied’s sales are not growing especially rapidly though; and to maintain comparability
with industry averages, we used year-end rather than average inventories.4-3b Days Sales Outstanding
Accounts receivable are evaluated by the days sales outstanding (DSO) ratio, also
called the average collection period (ACP).^5 It is calculated by dividing accountsInventory Turnover
Ratio
This ratio is calculated by
dividing sales by
inventories.Inventory Turnover
Ratio
This ratio is calculated by
dividing sales by
inventories.Days Sales Outstanding
(DSO)
This ratio is calculated by
dividing accounts
receivable by average
sales per day; it indicates
the average length of time
the firm must wait after
making a sale before it
receives cash.Days Sales Outstanding
(DSO)
This ratio is calculated by
dividing accounts
receivable by average
sales per day; it indicates
the average length of time
the firm must wait after
making a sale before it
receives cash.(^3) Our measure of inventory turnover is frequently used by established compilers of! nancial ratio statistics such
as Value Line and Dun & Bradstreet. However, you should recognize that other sources calculate inventory using
cost of goods sold in place of sales in the formula’s numerator. The rationale for this alternative measure is that
sales are stated at market prices; so if inventories are carried at cost, as they generally are, the calculated turnover
overstates the true turnover ratio. Therefore, it might be more appropriate to use cost of goods sold in place of
sales in the formula’s numerator. When evaluating and comparing! nancial ratios from various sources, it is
important to understand how those sources are speci! cally calculating! nancial ratios.
(^4) Preferably, the average inventory value should be calculated by summing the monthly! gures during the year
and dividing by 12. If monthly data are not available, the beginning and ending! gures can be added and then
divided by 2. Both methods adjust for growth but not for seasonal e" ects.
(^5) We could use the receivables turnover to evaluate receivables. Allied’s receivables turnover is $3,000/$375!
8 #. However, the DSO ratio is easier to interpret and judge.