Chapter 4 Analysis of Financial Statements 91receivable by the average daily sales to! nd how many days’ sales are tied up in
receivables. Thus, the DSO represents the average length of time the! rm must
wait after making a sale before receiving cash. Allied has 46 days sales outstand-
ing, well above the 36-day industry average:
Days sales outstanding (DSO)! ____Rec eiv ables
Average sales per day
! Receiv ables
Annual sales/365
! __$375
$3,000/365
! ___$375
$8.2192
! 45.625 days ≈ 46 days
Industry average! 36 days
The DSO can be compared with the industry average, but it is also evaluated
by comparing it with Allied’s credit terms. Allied’s credit policy calls for payment
within 30 days. So the fact that 46 days’ sales are outstanding, not 30 days’, indi-
cates that Allied’s customers, on average, are not paying their bills on time. This
deprives the company of funds that could be used to reduce bank loans or some
other type of costly capital. Moreover, the high average DSO indicates that if some
customers are paying on time, quite a few must be paying very late. Late-paying
customers often default, so their receivables may end up as bad debts that can
never be collected.^6 Note too that the trend in the DSO over the past few years has
been rising, but the credit policy has not been changed. This reinforces our belief
that Allied’s credit manager should take steps to collect receivables faster.
4-3c Fixed Assets Turnover Ratio
The! xed assets turnover ratio, which is the ratio of sales to net! xed assets, mea-
sures how effectively the! rm uses its plant and equipment:
Fixed assets turnover ratio! __Sales
Net! xed assets
! $3,000__
$1,000
! 3.0"
Industry average! 2.8"
Allied’s ratio of 3.0 times is slightly above the 2.8 industry average, indicating that
it is using its! xed assets at least as intensively as other! rms in the industry. There-
fore, Allied seems to have about the right amount of! xed assets relative to its
sales.
Potential problems may arise when interpreting the! xed assets turnover ratio.
Recall that! xed assets are shown on the balance sheet at their historical costs less
depreciation. In" ation has caused the value of many assets that were purchased in
the past to be seriously understated. Therefore, if we compare an old! rm whose
! xed assets have been depreciated with a new company with similar operations
that acquired its! xed assets only recently, the old! rm will probably have the higher
! xed assets turnover ratio. However, this would be more re" ective of the age of the
assets than of inef! ciency on the part of the new! rm. The accounting profession is
trying to develop procedures for making! nancial statements re" ect current values
rather than historical values, which would help us make better comparisons. How-
ever, at the moment, the problem still exists; so! nancial analysts must recognize
this problem and deal with it judgmentally. In Allied’s case, the issue is not serious
Fixed Assets Turnover
Ratio
The ratio of sales to net
fixed assets.Fixed Assets Turnover
Ratio
The ratio of sales to net
fixed assets.(^6) For example, if further analysis along the lines suggested in Part 6 of this text indicates that 85% of the
customers pay in 30 days, for the DSO to average 46 days, the remaining 15% must be paying, on average, in
136.67 days. Paying that late suggests! nancial di# culties. A DSO of 46 days would alert a good analyst of the
need to dig deeper.