 Hello and welcome to the session in which we would look at asset utilization ratio. To be more specific, we're going to be looking at total asset turnover, fixed asset turnover, inventory turnover, and days sales in receivable. Before I start, I would like to remind you to check out my website for headlactures.com, especially if you are an accounting student or a CPA candidate. If you're a CPA candidate, whether you are taken Wiley, Gleim, Roger, Becker, Sargent, or any other course, I don't replace your CPA prep course. I supplement. I can be a useful addition to your CPA course where I explain the material a little bit more in detail. So you could check out my CPA material. If you're an accounting student, you could check out my accounting courses. I have practically every accounting course covered that you will cover in college. If not for anything, check out my website to find out where does your university rank for the CPA exam. In other words, what's the passing, the pass rate for your university, overall pass rate and pass rate by section. Also, I have ranking by countries. Also, if you haven't connected with me on LinkedIn, please do so. Subscribe to my YouTube and follow me on Instagram and Facebook. The first sets of ratio we're going to be looking at is asset and fixed asset turnover. Now, the reason I put them together because they are similar. Let's examine the numerator. Numerator is sales in both assets. So notice we are taking sales and dividing sales by a different number. Sales by total average asset, the total, and sales by fixed asset. Let's say what they mean first so we can interpret them. We'll use some examples then we'll explain the overall picture. Basically, those ratios, whether it's total asset or fixed asset, measure the value of company sales or revenue relative to the value of assets and fixed asset. Let's start with the first ratio, this ratio here. Now, when you are dealing with ratios, the way you want to understand them is by using simple numbers to interpret them. Once you know how to interpret them, then you can apply them to any situation. So let's take a look at a company where they have sales of $1,000 and total assets of $10,000. Well, I use those numbers because they're going to give me an easy ratio, which is 10%. Now, how do we interpret 10%? First, you need to know what does the ratio mean. Well, what it tells me is this company have assets of $10,000 and from those $10,000 assets, they generated $1,000 in sales. What I can say is this, they are generating 10% of their sales from assets. So they are using, utilizing their milking their assets to generate from those assets 10%. Now, if another company, let's assume another company, they have $1,000 in sales, but $5,000 in assets, guess what? These two companies are not equal. Although the sales is the same, $1,000, this company, if this is company A and this is company B, company B is doing better because they're generating more sales, more sales per dollar amount than company B. So this is basically an efficiency ratio. Now, how can you improve this ratio? Obviously, you want this ratio to be as high as possible. How can you improve this ratio? Well, one way to do it, if you cannot increase your sales, lower your assets. Notice what we did here, lower your assets. Or if you could increase your sales without increasing your assets or do both at the same time, increase your sales and reduce your asset at the same time. So this is a good ratio. Now, is this 10% good? Is 20% good? For the asset turnover, each industry and each company is different. In a moment, I will have a comparison just to let you know that all ratios, you have to take them within a context. So you cannot interpret 10% good or bad unless you compare it to a competitor, compare it to another period, or compare it to the industry in general. So you could compare it to yourself from a prior period, you could compare it to a competitor, and you could compare it to the industry. Now, when you do those comparison, you have to take into account other factors. Like if you want to compare yourself to a competitor, you want to make sure you and the competitor are using the same revenue recognition principle, the same way you account for assets, so on and so forth. So there are many things you have to take into account when you're using those ratios in the real world. Now, for certain companies, fixed asset is important. For example, construction companies, places like Home Depot, because they have a lot of property, plant, and equipment where there is a high use of fixed asset. We could do a similar computation basically, looking at sales, $1,000 in sales, I'm going to be using the same numbers, divided by 10,000 in fixed asset because total asset include also current assets. Now what we're doing, we're only focusing on how much your fixed asset are contributing to your sales. So if you want to compare two retailers, like for example, Home Depot to Lowe's, rather than comparing total assets, you want to compare how well are they using their fixed asset. And there's something I should have mentioned from the beginning. Let me point out something to you. Notice in the numerator, we have sales as one figure. In the denominator, we use average asset. Average assets means year one plus year two divided by two, or the beginning of the year plus the end of the year divided by two, the same thing. Why do we use average asset? And in the numerator, we use only one figure, not the average sales. Well, here's why. Because sales, when a company generates sales, they count the sales for the whole year. However, when we're looking at assets, assets are a point, it's a balance sheet number, and it's a point in time. So you don't want to take a number that you worked on the whole year and compare it to the last day of the asset. Why? Because the last day of the asset, you could get rid of some of your assets and make yourself look good. So what we do is we'll take beginning asset or year one asset plus year two divided by two. This way, we average our asset out. So this way, the numerator and the denominator are using the same benchmark basically. Okay, so that's why we use, when we're looking at the balance sheet, we use average numbers. When we're looking at the income statement, we use a single figure because the income statement measure a period of time. Once again, to make sense of those ratios, for example, let's assume this is the total asset turnover for a company, we can compare it from year to year. For example, it's basically consistent 2015, 2016, 2017. Notice, the average industry is 0.7. So the industry is better than this company, whatever this company is. So this is how you compare the ratios to make sense of them. You compare them to something else. So this company, it's not doing as good as the industry, at least for 2017 because we have the average industry for 2017. The industry, they're generating 70 cents for every dollar in asset. They're generating 70 cents in sales and every dollar in assets. This company is only generating 60 pennies. That's a big difference. That's a big difference. Let's take a look at the second asset because this is about asset utilization inventory. Inventory, well, we can compute inventory turnover. How do we compute inventory turnover? We take cost of goods sold, which is an income statement account divided by average inventory, which is the beginning of the period inventory plus the end of the period or year one plus year two. Same concept. We're using average in the denominator because it's a balance sheet account. What does it tell us? This ratio is showing how many times a company has sold and replaced its inventory during a given period. So let's assume this is a store and how many times we filled out the store, sold everything, filled out the store again, sold everything, filled out the store again, then sold everything. We want to do this as many times as possible. How do we compute this ratio to turnover? Because we want our turnover to be high, assuming obviously we are making a profit. Because if we're selling our inventory at loss, we can really sell our inventory really quick. But if we're not selling it at a profit, it's not good. So again, let's use some numbers. Let's use for cost of goods sold 1200 and let's use for average. Our average inventory is 100. So 1200 divided by 100 equal to 12. And I did this on purpose. What does that mean? It means you turn over your inventory 12 times a year. What does that really mean? It means every month. So if this is a store, again, please don't don't judge me for my art skills. So what you do is you fill out the store once every month, then by the end of the month, everything is sold on average and you fill it out again. And you do this 12 times. Now you want this ratio to be as high as possible. The best way is to have this ratio 365. So every time you buy the product, you sell it immediately, right? So this is basically you are, you know, you're not, you don't have any inventory, you keep on turning over your inventory. Now this ratio, there's a lot of, a lot of things you have to be aware of when you're comparing one company to another. For example, one company could be using FIFO, another company could be using LIFO for their inventory. Also, some companies, what they do, they might have a large year in purchase. And as a result, they may increase their average inventory, which in turn lower their turnover. So when you're looking at these ratios, you always have to go a little bit in the tails, a little bit further to find out what is going on. Okay. Also you have to take a look at inflation for that matter. For example, inventory. For example, if you're comparing year one to year two or the beginning of the year versus the end and you have inflation, your inventory figures at the end of the year might be higher. Not because you have more units, just because you are paying more, the cost is higher. So always, and always ratios, you have to be careful. Now from this ratio, we can compute something called days, sales and inventory. In other words, how many days your inventory is sitting on the shelves? Like, okay, it's 12 times. How many days it's sitting on the shelves? Again, the reason I chose this, because it's an easy number to compute, looks at the average time a company can turn its inventory into sales. Okay. It's taking, if you take inventory divided by cost of goods sold times 365, or the way I like to do it, basically, if you already computed inventory turnover, take 365 divided by the turnover, which happens to be 12. So approximately, it's taken you 30 days on average, 30 days to sell your inventory. Now you want this number to be low. In other words, you don't want your inventory to be sitting in your store for a long period of time. For example, Apple. Okay. Apple has really low days high, high inventory turnover, and low days sales inventory. On average, at some point, it's like seven days, literally one week, seven days. So Apple, they turn over their inventory once every week, seven days. So that's pretty good. It means they have a high turnover, low day sales and inventory. Let's take a look at another asset, which is receivable. Well, we're going to first look at account receivable turnover. It's very similar to, in concept to, inventory turnover. We're both talking about turnover. What are we looking at here when we compute the account receivable turnover? Where we're looking at how many times you sell on credit, you collect the money, sell on credit, collect your money, sell on credit, collect the money, sell on credit, collect the money, sell on credit, collect the money, so on and so forth. Now the best way, like a typical average should be 12. In other words, you sell your product and you give your customers 30 days to pay a month. It means you have an account receivable turnover of 12. It means every 30 days you collect your inventory. Now how do we compute this? Now in the real world, it's hard to compute this number unless you have inside information because the true way to compute this is take an average account receivable divided by credit sales, to be more specific, net credit sales. It means sales minus returns and allowances minus discounts, but companies don't provide you with credit sales. So in most textbooks, they say average receivable divided by sales, but it's not really meaningful and it's not true in a sense that you should compute it by net credit sales, not by sales. So this ratio, you have to be careful whether the company is using cash method or a cruel, whether the company has selling on account. For example, a lot of companies, they don't sell on account. In other words, they don't sell using their own credit. They accept credit cards, but for example, Home Depot, Home Depot, they have their own credit. Therefore, this ratio will make sense because they're selling you, they're using Home Depot credit card, if you use their credit card, so they can measure how long it's taking to collect. So this ratio is important in terms of credit policy. For example, if you want to have a good turnover, you have to make sure you have a good credit policy. In other words, don't give credit to everyone. If you do give credit to everyone, your sales will go up, but when it comes to collection, your receivable will stay longer on the books and you're going to have more bad debt. Also, it tells us about your collection policy, how well you are collecting your money. You have a good collection department. So this ratio could be used externally. It could be used internally by management to manage the company. Also, this ratio is affected by macroeconomics factor. For example, if the country goes through a recession, like the financial crisis or COVID or who knows what's going to happen next, people are, if they don't have money to pay their home depot, they're not going to pay their home depot. They're going to pay their mortgage first. Therefore, this ratio will be affected by factors like this. When you study this ratio, you have to kind of look at many factors when you are comparing this ratio to prior periods. From this ratio, we have something similar to today's sales and inventory. We have day sales and receivable or average collection period. Again, how many days it's taken you on average to collect your money? So it's the account receivable per dollar of daily sales and we can compute this by taking average account receivable divided by annual sales. Again, here annual sales is questionable and from a textbook perspective divided by 365. Also, what we can do, we can take, once we find the turnover, once we find the turnover, we can take the turnover divided by 365 to find this ratio. I'm sorry, not 365 divided by the turnover. So if your turnover is 12, let's assume this number happens to be 12, which is, again, I can make it 12, 1200 and 100 in credit sales, which make it 12. Then on average, it's taken you 30 days to collect your receivable. Now, if last year it was taken you 40 days, well, you either improved your collection policy or improved your credit policy, or if last year was taken you 20 days, then your credit policy is something wrong with your credit policy or your collection policy, or we have some macro economics factor that people are simply not paying the bills because they have other priorities to worry about. For example, this company has taken them 100, almost 100 days to collect their money. Again, is this good? Is this bad? We really don't know. We have to compare this company to the industry. So if the industry is, let's assume 60 days, well, that's really bad. It doesn't really have to be bad. Why? Because let's assume you want to take your chance. You want to sell to less credit worthy customers because you want to increase your market share, then that's fine. If that's what you want to do. But generally speaking, you don't want to be too far away from the industry in general, unless you have a really good reason. If your reason is to obtain market share, then by all means sell to less credit worthy client, you'll have a longer collection period. As always, I'm going to invite you to like my recording, share it, and I'm going to remind you about my website, farhatlectures.com, whether you are studying for your CPA or your accounting courses. I don't replace these courses. So if you're taking any of these courses, I don't replace them. I can't replace them. I wish I can, but I can't. That's not what I do. I can add value to these courses if you sign up to my website. So check out my website, farhatlectures.com, study hard, stay safe, and good luck.