Use turnover ratios to see if acompany’s management is using its assets effectivelyto generate profits.
Every company management team aims to deploy its assets to generatethe most profits possible. It doesn’t do any goodfor a company to own assets, such as factories, inventory, or evencash, if they’re not being used to maximumadvantage. There are three ratios that investors typically evaluateto measure the efficiency of company management: assetturnover ratio, inventory turnoverratio, and receivable turnover ratio.
The first ratio to consider is the asset turnoverratio, which assesses the sales that a company cangenerate for each dollar of assets it owns—the higher the assetturnover ratio, the better. Companies with high asset turnover ratioscan thrive even with low profit margins.
The asset turnover ratio is calculated using the formula in Example 4-36.
Example4-36.Formula for the asset turnover ratio
Asset Turnover Ratio = Total Revenue for Period / Average Assets for Period
Companies report the value of their assets on their balance sheetsincluded in the financial statement section of their SEC 10-Q and10-K filings. However, they report the value of those assets as theystood at the end of the year. You can calculate the average assetsfor the period by averaging the year-end values for total assets forthe current and previous years.
Tip
You can use total assets in place of average assets, mostly for thesake of simplicity. However, average assets better represent acompany’s efficiency.
The financial data spreadsheets available at EdgarScan (http://edgarscan.pwcglobal.com) provide aquick way to obtain the necessary values.
Let’s look at Home Depot’s assetturnover ratio. Table 4-4 shows pertinent HomeDepot financials.
Table4-4.Home Depot measures from EdgarScan needed for calculating the asset turnover ratio
Financial measure | Value in millions |
---|---|
2003 total operating revenue | $58,247.0 |
2003 total assets | $30,011.0 |
2002 total assets | $26,394.0 |
Using the assets from each period, the average assets are $28,202.5million. Plug these values into the formula to determine HomeDepot’s asset turnover for the year, as shown inExample 4-37.
Example4-37.Formula for Home Depot’s asset turnover ratio
Home Depot's Asset Turnover Ratio = 58,247.0 / 28,202.5 = 2.1
You can use the AVERAGE
function to calculate theaverage assets, as shown in Example 4-38.
Example4-38.Excel function to calculate average assets
Average Assets = AVERAGE(B2:C2)
MSN Money (http://money.msn.com)provides asset turnover and other turnover ratios for companies,industry turnover averages, and average turnover values for theS&P 500 index. As you can see in Figure 4-14,Home Depot’s asset turnover ratio of 1.9 comparesfavorably to other companies in its industry, which has an averageasset turnover ratio of 1.8.
Tip
Companies with high asset turnover ratios tend to have lower profitmargins (and vice versa). That doesn’t mean thatcompanies with higher or lower asset turnover ratios are betterlong-term investments. It’s just an indication of acommon business strategy of selling a high volume of goods at a smallincrease over cost.
The inventory turnover ratio is an indicator of how quickly acompany moves its inventory out of warehouses, factories, or stores,and into the hands of customers. The formula to calculate the ratiolooks like Example 4-39.
Example4-39.Formula for inventory turnover ratio
Inventory Turnover Ratio = Total Revenue / Average Inventory
Total revenue appears on the income statement and inventory appearson the balance sheet. You must calculate the average value ofinventory from the most recently reported inventory value and thevalue from the same period a year earlier. Using a spreadsheet ofextracted financial data downloaded from EdgarScan (http://edgarscan.pwcglobal.com), you canquickly calculate the inventory turnover ratio for a company.
Tip
Sometimes, the inventory turnover ratio is calculated by dividing thecost of goods sold by average inventory. Either method isacceptable—just make sure that you compute your ratios usingthe same method when comparing a company to its competitors orindustry.
Continuing the evaluation of Home Depot’s efficiencyratios, Table 4-5 shows pertinent Home Depotfinancials for calculating the inventory turnover ratio.
Table4-5.Home Depot measures from EdgarScan needed for calculating the inventory turnover ratio
Financial measure | Value in millions |
---|---|
2003 total operating revenue | $58,247.0 |
2003 total inventories | $8,338.0 |
2002 total inventories | $5,489.0 |
Using the assets from each period, the average inventory is $6,913.5million. Using these values, Example 4-40 shows HomeDepot’s inventory turnover ratio for the year.
Example4-40.Home Depot’s inventory turnover ratio
Home Depot's Inventory Turnover Ratio = 58,247.0 / $6,913.5 = 8.4
When it comes to evaluating the inventory turnover ratio, higher isbetter. As is standard practice, you should compare acompany’s inventory turnover to its competitors.Retail stores and grocery chains usually have higher rates ofinventory turnover, because they sell a lot of low-cost products.Heavy equipment makers generally have lower turnover ratios, becausebulldozers and cranes each sell for hundreds of thousands (or evenmillions) of dollars. You can see average inventory turnover ratiosin the sidebar earlier in this hack.
Tip
Financial companies don’t have inventory likemanufacturing or retail companies do, so this ratiodoesn’t apply to them.
You can quickly check a company’s inventory turnoverratio at MSN Money (http://money.msn.com) and compare it to theindustry average inventory turnover ratio and the average for theS&P 500 index. As shown in Figure 4-14, HomeDepot’s inventory turnover ratio of 4.9 comparesfavorably to other companies in its industry, which average 4.7.
Product inventories are the least liquid assets that a company owns,and unsold inventory quickly becomes a money-losing proposition. Lastyear’s fashions become this year’sbargain basem*nt buys, outdated technology lands in the junk pile,and spoiled food goes into the garbage. This is whyit’s important for companies to manage theirinventories closely. In the last decade, industries ranging from automanufacturers to computer hardware makers have increasingly turned tomethods that keep their inventory levels at a minimum, such asjust in time delivery of parts and materialsfrom suppliers, or building goods to order that are immediatelyshipped to customers, as Dell does with computers.
A low inventory turnover ratio is sometimes a signal that a companyis out of step with customer demand for its products—itsproducts are not succeeding in the marketplace, because ofobsolescence or poor quality. However, companies sometimes stock uptheir warehouses to prepare for a new product rollout or for theholiday sale season, so you should dig deeper into the reasons.
The third ratio to consider is the receivables turnoverratio. Accounts receivable (also known as receivables) area company’s uncollected income from customers, suchas unpaid invoices. Higher receivables turnover ratios are preferableto lower ones, because companies run the risk of never collecting onopen invoices if they delay too long. In addition, those receivablesrepresent income, which most companies need to pay their own bills.Example 4-41 shows the formula for receivablesturnover ratio.
Example4-41.Formula for receivables turnover ratio
Receivables Turnover Ratio = Total Revenue / Average Receivables
The receivables turnover ratio reveals how many times a company hascollected its receivables during a period. Unlike assets andinventories, receivables have a more immediate element of timeliness,and you use more recent values to calculate the receivables turnoverratio. Instead of averaging the receivables from the current andprior years, you calculate the average from the most recent twoquarters.
Tip
Some analysts and data providers calculate average receivables byusing two year-end values, whereas others use five quarters. As longas you use the same method when looking at competitors or industryaverages, you can use any method to compute average receivables.
Continuing the evaluation of Home Depot’s efficiencyratios, Table 4-6 shows pertinent Home Depotfinancials for calculating the receivables turnover ratio.
Table4-6.Home Depot measures from EdgarScan needed for calculating the receivables turnover ratio
Financial measure | Value in millions |
---|---|
2003 total operating revenue | $58,247.0 |
2003 total receivables | $1,072.0 |
Third quarter 2002 total receivables | $1,379.0 |
Using these values, you can calculate Home Depot’sreceivables turnover ratio for the year, as shown in Example 4-42.
Example4-42.Home Depot’s receivables turnover ratio
Home Depot's Receivables Turnover Ratio = 58,247.0 / 1,225.5 = 47.5
Is a receivables turnover ratio of 47.5 good? As with most retailstores, the bulk of Home Depot’s customers pay withcash or credit cards that the company almost immediately turns intocash at the bank, so the company’s ratio is quitegood. You can see average inventory turnover ratios in the earliersidebar “Industry Average Efficiency Turnover Ratios(2002).” As with the inventory turnover ratio,financial stocks don’t report receivables, so thereceivables turnover ratio isn’t applicable forthese companies.
You can also quickly compare the company to its industry at MSNMoney, as shown in Figure 4-14. A low receivablesturnover ratio compared to the competition is cause for concern. HomeDepot doesn’t compare as favorably with this ratioas it does with other efficiency ratios. Its receivables turnoverratio of 46.8 is slightly lower than the industry average of 51.4,but it is still high enough to safeguard the company from obsoleteinventory.
Tip
Very high receivables turnover ratios, such as HomeDepot’s, indicate highly efficient companies thatcan usually delay paying their own bills while quickly collecting onmoney that’s owed them. By doing this, companiesobtain the equivalent of an interest-free loan. Averages vary byindustry, so a 30-day payment period could be common practice orcompletely unattainable.
In addition to MSN Money, you can also find management effectivenessratios for companies and industries calculated at Reuters Investor(http://www.investor.reuters.com).
—Douglas Gerlach