CHAPTER 5 Revenue Recognition and Profitability Analysis 269 Profitability Analysis Chapter 3 provided an overview of financial statement analysis and introduced some of the common ratios used in risk analysis to investigate a company’s liquidity and long-term solvency. We now look at ratios related to profitability analysis. Activity Ratios One key to profitability is how well a company manages and utilizes its assets. Some ratios are designed to evaluate a company’s effectiveness in managing assets. Of particular interest are the activity, or turnover ratios, of certain assets. The greater the number of times an asset turns over—the higher the ratio—the fewer assets are required to maintain a given level of activity (revenue). Given that a company incurs costs to finance its assets with debt (paying interest) or equity (paying dividends), high turnovers are usually attractive. Although, in concept, the activity or turnover can be measured for any asset, activity ratios are most frequently calculated for total assets, accounts receivable, and inventory. These ratios are calculated as follows: Asset turnover ratio 5 _ ____N__ e_t _s _al_e_s_ ____Average total assets Receivables turnover ratio 5 _________ _ _N_e_t_ s_a_l_es_ _ _________Average accounts receivable (net) Cost of goods sold ________ ________ Average inventory Inventory turnover ratio 5 ASSET TURNOVER. A broad measure of asset efficiency is the asset turnover ratio . The ratio is computed by dividing a company’s net sales or revenues by the average total assets available for use during a period. The denominator, average assets, is determined by adding beginning and ending total assets and dividing by two. The asset turnover ratio provides an indication of how efficiently a company utilizes all of its assets to generate revenue. RECEIVABLES TURNOVER. The receivables turnover ratio is calculated by dividing a period’s net credit sales by the average net accounts receivable. Because income statements seldom distinguish between cash sales and credit sales, this ratio usually is computed using total net sales as the numerator. The denominator, average accounts receivable, is determined by adding beginning and ending net accounts receivable (gross accounts receivable less allowance for uncollectible accounts) and dividing by two. 30 The receivables turnover ratio provides an indication of a company’s efficiency in collecting receivables. The ratio shows the number of times during a period that the average accounts receivable balance is collected. The higher the ratio, the shorter the average time between credit sales and cash collection. A convenient extension is the average collection period . This measure is computed simply by dividing 365 days by the receivables turnover ratio. The result is an approximation of the number of days the average accounts receivable balance is outstanding. Average collection period 5 _______ _ __3_6_5_ __ _______Receivables turnover ratio Monitoring the receivables turnover ratio (and average collection period) over time can provide useful information about a company’s future prospects. For example, a decline in the receivables turnover ratio (an increase in the average collection period) could be an indication that sales are declining because of customer dissatisfaction with the company’s products. Another possible explanation is that the company has changed its credit policy and is granting extended credit terms in order to maintain customers. Either explanation could PART D ● LO5–10 Activity ratios measure a company’s efficiency in managing its assets. The asset turnover ratio measures a company’s efficiency in using assets to generate revenue. The receivables turnover ratio offers an indication of how quickly a company is able to collect its accounts receivable. 30 Although net accounts receivable typically is used in practice for the denominator of receivables turnover, some prefer to use gross accounts receivable. Why? As the allowance for bad debts increases, net accounts receivable decreases, so if net accounts receivable is in the denominator, more bad debts have the effect of decreasing the denominator and therefore increasing receivables turnover. All else equal, an analyst would rather see receivables turnover improve because of more sales or less gross receivables, and not because of an increase in the allowance for bad debts. The average collection period indicates the average age of accounts receivable.
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