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Efficiency ratios, key to managing assets

Alagappan Arunachalam

Though analysis of asset management ratios has limitations, historical and peer comparisons help in gauging the efficiency of the management in utilising its assets.

Efficiency ratios, also known as asset management ratios, are the key to deciphering how well a business manages and uses its assets. These ratios measure a company's efficiency in applying its assets and play a role in determining the returns generated.

Asset turnover, debtors' turnover and inventory turnover are among the key efficiency ratios.

Asset turnover ratio

This ratio is calculated by dividing the revenue by total assets. This ratio, which forms part of the DuPont valuation model (of which profit margin and asset multiplier are the two other ratios), measures the productivity of a firm's assets. Return on equity is directly related to this measure.

Companies that operate on thin profit margins tend to have high asset turnover ratios while those with large profit margins tend to score low on this parameter.

This ratio can be further subdivided into fixed asset turnover ratio and working capital turnover ratio. While a high fixed asset turnover ratio is desirable, a substantially high ratio compared to its peers indicates that the company could be operating close to its full capacity.

The asset turnover ratio is more widely used in the investment arena than the debtors' turnover and inventory turnover ratios. However, the latter provide a good picture of a company's current financial position.

Debtors Turnover Ratio

This ratio is arrived at by dividing gross sales by receivables (debtors and bills receivable). The debtor turnover ratio usually varies across sectors based on whether it is common practice in the industry to make sales on cash or a credit basis.

Industries where the bulk of sales are made on a cash-and-carry basis have a high debtor turnover ratio. Players in the cigarettes industry serve as examples. Godfrey Philips clocked an average of 204 times in 2005-06.

However, how a company's debtor turnover ratio compares to its peers in the same industry is a good gauge of its relationship with its customers and cash management systems.

The inverse of this ratio multiplied by 365 (where the time period of the relevant cost of goods sold is 365 days) indicates the days taken by a company to converts its bills into cash. This ratio, which indicates the efficiency with which credit or collection managers operate, is sometimes referred to as thug ratio.

The trend in the credit period over several years serves as a barometer of a company's liquidity position — a lengthening credit period could be a sign that a cash crunch is around the corner.

Inventory Turnover Ratio

This ratio, which is arrived at by dividing cost of goods sold by inventory (finished goods), indicates the rapidity with which a company is able to convert its output into revenues, by way of sales. Companies in the perishables business tend to have a high inventory turnover ratio while those that deal in goods with a long-shelf life tend to have a low inventory turnover ratio.

The inventory turnover ratio could be further broken down into finished goods turnover ratio, work-in-progress turnover ratio and raw materials turnover ratio.

For instance, the performance of Heritage Foods and Kohinoor Foods, which operate in the broadly classified FMCG industry. Heritage Foods had an average inventory turnover ratio of about 16 in FY-06, while Kohinoor Foods sold goods worth (on cost basis) only about two times its inventory.

The inverse of this ratio multiplied by 365 (where time period of the relevant cost of goods sold is 365 days) indicates the days taken by the company to sell its goods.

Using this ratio, one would be able to gauge that Heritage Foods' products (finished goods) had a waiting time of about 23 days in the warehouse before its goods are sold.

Kohinoor Foods' products are stored for about 211 days before they are sold. Though this ratio indicates that Heritage Foods scores over Kohinoor Foods, ranking companies that operate in different businesses on this parameter would be misleading.

While Heritage Foods makes dairy products that have low-shelf life and high-storage costs, Kohinoor Foods operates in the rice business where the shelf life is longer.

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.

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