The Mathematics of Money

Copyright © 2008, The McGraw-Hill Companies, Inc.

Example 12.3.3 Calculate the inventory turnover at cost and the average collection

days for Thomas Hydrometer Sales. Explain what these ratios tell you.

To calculate the inventory turnover, we fi rst calculate the average inventory:

Average inventory 

$32,535,000  $22,982,651

__ 2  $27,758,826

The inventory turnover is then:

Inventory turnover 

$74,438,275

____________

$27,758,826

 2.68 times

The company sold 2.68 times as much merchandise in the past year as its average amount

of merchandise in inventory.

To fi nd the average collection days, we fi rst calculate the net sales per day:

Net sales per day 

$74,438,275

____ 360  $206,773

Then, to calculate the average collection days:

Average collection days 

$1,242,075

___________

$206,773

 6 days

It takes on average 6 days from the date of sale to collect payment for the sale.

As with our other ratios, what we would consider good values for these ratios can depend

quite a bit on the type of business. A retail fruit market selling perishable fruits and veg-

etables would hopefully be turning its inventory over very quickly, and hence have a much

higher turnover ratio, than a jeweler who might take more time to sell his stock. Likewise,

the average collection days can vary, depending on how much a given type of business

would be expected to be selling on credit.

Balance Sheet Ratios

Balance sheet ratios are measurements of a business’s financial strength, based on values

listed on the company’s balance sheet. Three commonly used ratios are the current ratio

and quick ratio (or acid test), both measurements of the company’s ability to make good

on its near term financial obligations, and the liabilities-to-equity ratio, a measurement of

how much debt the company has in relation to its overall financial position.

These three ratios are defined as follows:

Definitions 12.3.7, 12.3.8, and 12.3.9

Ratio Formula What It Tells You

Current ratio _______________Current assets

Current liabilities^

A comparison of current assets to current liabilities.

A ratio greater than 1 means the business has

more current assets than liabilities. A ratio less than

1 raises questions about the company’s ability to

cover near-term obligations.

Quick ratio

Current assets 
 Inventory 
 Prepaid expenses

_________________________________________

Current liabilities

A comparison of assets that can be put to

immediate use against near-term liabilities. The

interpretation is similar to current ratio, except that

current assets less easily converted to cash don’t

count.

Liabilities-to-

equity ratio^

_____________To tal liabilities

Owners’ equity^

A measurement of how deeply the business is

in debt. As a rule of thumb, a ratio greater than

1 indicates a high debt load.

12.3 Financial Ratios 511