 Oh, and welcome to the session. This is Professor Farhad. In the session, we would look at the series of ratios, which are the activity ratios. This topic is covered in intermediate accounting, as well as financial statement analysis, covered on the CPABEC exam. As always, I would like to remind you, if you haven't connected with me on LinkedIn, please do so on YouTube. I have 1500 plus, covering all these courses, lectures, covering all these courses. Please, like my lectures, share them, put them in the playlist. Let the world know about them. If you're benefiting from my lecture, it means other people might benefit as well. I do have a website on my website. In addition to the lectures, you'll find additional resources, such as the PowerPoint slides, quizzes, notes, additional exercises, and you will find 2000 plus CPA questions. Please check out my website. If you are looking, if you're studying for the CPA or CFA exam, studypal.co is an artificial intelligence, studybody platform that matches you with a candidate. They are available in 85 countries in 2,500 cities. Let's talk about the activity ratios. What are the activity ratios? Basically, they measure how effectively the company uses their assets. So you have assets, you have resources, but how well you are using those resources. Specifically, we're gonna be looking at a count receivable. And within the count receivable, we're gonna compute the count receivable turnover, day sales and collected, and doubtful account as a percentage of receivable. We're gonna look at the inventory. We're gonna look at inventory turnover, day sales and inventory, conversion period or the operating cycle. And we're gonna look overall at asset turnover, just from a macro perspective. So those are the three measurements. And notice account receivable and inventory, those two are part of the current ratio. So we looked at those in the liquidity ratios. So all the ratios, they go hand in hand. If you want to look at all the ratios, it will take you forever. I'm breaking down into pieces, but I want you to keep in mind as we are going inventory and account receivable turnover, think about current ratio, because both of these figures goes into the current ratio as well as asset test ratio. Let's start with the count receivable turnover. First, how do we compute account receivable turnover? We'll take net sales and we need to talk about this divided by average net receivable. Average is the beginning plus the ending divided by two or year one plus year two divided by two. It measures the liquidity of receivable or how fast we are turning over our receivable. Okay, so first let's take a look at the numerator. The numerator is we should only have credit sales in the numerator. Now, in the real world, financial statements for companies, they don't disclose how much the cash versus the credit sales. So if you look at a company's annual report, they will not tell you how much cash versus credit sales they have because it's part of their competitive advantage. They don't want to reveal this information. They are not required to do so. So if cash is a significant portion of the company's sales, then this ratio is not as helpful, okay? However, if the proportion of cash to total sales is relatively stable, then using this ratio will be a good indicator from year to year. What does that mean? Let's assume cash is 30% of, for every $100 in sales, 30% cash, obviously must be the $70 sale. So the ratio is 30%. So if that ratio is stable, in other words, on average every year of our total sales, 30% cash, 70% receivable, then this ratio makes sense. So the point I'm trying to make, we always have to look at ratios and dissect them to see if they make any sense or not. The denominator, pretty straightforward, the average average is taking the beginning plus ending divide by two. So let's take a look at an example, just kind of look at some numbers. Let's assume net sales, 1.2 million, and the average net receivable happens to be 235,000 and some change 300. Well, if we do so, let me just go ahead and compute this. And if we take 1.2 million divided by 235,300, we'll get 5.1, 5.09, I'm just gonna put 5.1. What does it mean? So I'm gonna give you a picture, what does 5.1 mean? This is what the picture looks like. We turn over our inventory one, two, May, three July, four September, five November and a little bit over by December. What does that mean? It means we sell on account, collect the receivable five, almost five times a year. So wherever we make sales in January, we almost collected in March, March, we collect in May, so on and so forth. So we collect the inventory almost five times. So what does that tell us? Well, for one thing, before we proceed, we hire this ratio, the better off we are, it means we are selling more and collecting the money. But receivable turnover gives you information about the quality and liquidity of receivable. What is the quality? What does it mean? Quality, quality means defer the likelihood of collecting without any losses. So if you have a good receivable, you should be able to collect most of it without having any bad debt as less bad debt as possible. A measure of this likelihood is the proportion of receivable within terms of payments said by the company. So how do I know I'm doing a good job? Well, if I'm giving them 30 days, I'm gonna be collecting every 30 days. So what is my standard? Now experience always showed that the longer a receivable is outstanding. It's not collected, the lower the likelihood you're going to collect your money. So once a receivable, it's assuming you're giving your customers 45 days and now your customers are, they passed the 45 days and the longer it takes them to pay, the more likelihood you are not gonna be paid and the lower the quality is your receivable. Liquidity, refer to the speed and converting account receivable into cash. The receivable turnover kind of measure the speed. How fast? How fast? For example, if we look at this picture, for example, if the receivable was ending here, it will be faster, but it's, you know, so it tells you how good is the quality and how fast. Now, another related ratio to receivable is something called days, sales and receivable. How do we compute the days, sales and receivable? One way to do it is to take receivable, which was 235, 300, divided by net sales, 1.2 million, multiply this by 365. Multiply this by 365. Another way to compute days, sales and collected, simply put, take the number 365 or 360, depending on how many days you want to count as working days in the year, but 360 or 365, whatever you want to choose, it's not gonna make that much of a difference, 365 days and divided by the turnover that you computed in step one, which we happen to be 5.1. So if we do this, I prefer this. I like this one, the 365 divided by 5.1 and that's gonna give us 71 in the answer, 71 days, 71 days. So this, and if we use this formula, that's gonna give you 71 days as well. So this day sales and receivable or day sales in collected, sometimes it's called in collected, sometimes it's called in receivable, measure the number of days it takes on average to collect your money. Now also, you want this number to be as low as possible. You want to collect your money every 10 days. I mean, between 71 days and 30 days, you prefer to collect your money every 30 days. Between 30 days and 10 days, you'll prefer to collect your money 30 days. So you have to do, those ratios don't make any sense. So is 72 good or not good? You have to compare the ratios with your credit terms. What does it mean your credit terms? How many days you set for your company? If you set for your company 40 days, you want to collect your money 40 days, you're giving the customers 40 days and on average, it's taking you 71 days to collect the money. Well, that's not good. That's a red signal. It could be because of poor collection effort. Your employees are not doing a good job. Delay in customer payment. The customer are not paying on time. Customers in financial distress, the industry that you are serving. The customers, your customers, they are concentrated in an industry where it's not doing good. So those are three possible reasons. The first condition basically is the company will have to fix that if it's a poor collection effort. The other two, it's gonna tell you more about the quality and the liquidity of the account receivable. So that's very important because you have no control over if the customer is not paying due to financial distress, that's a problem. It means you selected the wrong industry, you selected the wrong customer. It's harder to deal with. A third ratio that usually it's useful, these isn't it's useful because when you compute account receivable, some use net, which is net of bad debt and some use the gross. So it makes a difference whether you use the net or the gross, but one way to kind of look at that net versus gross is to look at the provisional for doubtful account and divide that by gross receivable. For example, if you have, if you are, if your provisional is 10 and your gross receivable is 100, well, it means off your receivable 10% you assume you will not be able to collect. It's gonna be provisions for, you think it's not gonna collect. Therefore, this ratio is good because some people use gross, some companies use the net, which one is better? Well, you have to keep in mind if you use the net, okay, it's net of receivable the resulting computation are affected by the company's degree of conservatism. Simply put, if you're using the net receivable what's gonna happen is if you are conservative you're gonna estimate a lot of in collectible. As a result, it's gonna influence the number versus another company that's not as conservative under estimate and therefore the ratios will become not comparable, okay? So if this ratio is increasing let's assume this is 10 divided by 100 and let's assume it's increasing. Let's assume we went from five, five in provision gross receivable 100. So this is gonna give us what? It's gonna give us, now let's assume it's increasing. Let's make it 20. So we're gonna go from 10 to 20. So now this ratio is 20 increase. Increase in this ratio over time indicate a decline in the collectibility of receivable. So this is a good way to see how much are you estimating versus your receivable? If this ratio going up it means there is a decline in the collectibility because your provision is getting longer and longer, a bigger, larger and larger. Now the opposite is true if you have a decrease let's assume you went from 10 to five this will make it five, there's a decrease. It suggests improvement of collectibility. So you're doing a good job or the need to reevaluate the adequacy of the doubtful account. Maybe this number is not correct. Maybe you want to reevaluate this. So those are indications, those are indications. Now the next thing we're gonna look at is inventory turnover. Inventory turnover, again inventory is a current asset just like account receivable and inventory proceed account receivable. So before we have an account receivable we have inventory, we have inventory. Therefore we want to know how fast we are turning our inventory. Just to give you some simple numbers if we have cost of goods sold of 120,000 and we have the average inventory is 20,000. Okay, 120 divided by 20. We can say that the inventory turnover is six time. What does it mean six time? Well, just like the account receivable. One, two, three, four, five, six. It means we sell our inventory. We buy inventory here. We sell everything by this point during the year and we buy the inventory again on average. That's one, that's two, that's three, that's four, that's five and that's six. It means we kind of think of it as a store. You filled out the store once and you sold everything. You filled out the store twice, you sold everything. You did that six times. Now, obviously the faster the better. You want to turn over your inventory as much as possible as long as you are making a profit. So this measure the speed at which inventory move through and out of the company, okay? Now, why is this inventory important? Because you don't want to have, you don't want this to be, you don't want this to be long. You don't want this, you don't want this period to be long. In other words, you don't want the inventory to sit too long for many reasons. There's a storage cost associated with inventory. There's insurance cost. The more inventory, the more you have to pay insurance. And some places you have to pay taxes on inventory. Upsolescence, that's important. Basically your inventory becomes basically obsolete due to changes in technology. Physical deterioration, physically it deteriorate. Maybe where you're storing your inventory, it's not a good place. And you're gonna tie up funds that could be used somewhere else. So having too much inventory is not good. That's why we have to know how fast it's turning over and we want to see, we want to see how can we improve this turnover. Also we have to be careful when we compute those ratios which inventory method we are using. Because if you have one company using FIFO you might have two different figures. Now most companies, when they disclose, they tell you what they are using and sometimes they tell you if we use FIFO versus FIFO, the number will be different. Another related ratio to inventory turnover is day sales and inventory. And it's very similar to day sales in collectible or day sales in receivable. Basically taken 365 divided by the inventory turnover in our situation, I chose a number of six. Now I'm gonna tell you in terms of days, 365 divided by six on average, it's taken us 61 days, on average, taken us 61 days, almost two month which is if they turn over a six. It means six times a year. It means every two month you turn over your inventory. So it tells us how long it's taken us to sell the average assuming a given rate of sales. Now this ratio, day sales and inventory and inventory turnover, sometime the annual is not good because if the business is seasonal, you don't want to look at the overall average. So you wanna compute it at a low for a shorter period of time. And all ratios, you can do that with all ratios as long as you make the proper adjustment for the numerator and the denominator. Inventory turnover offer a measure of both quality and liquidity of the inventory. Quality is, what is your ability to dispose of the asset? Can you find the buyer and if they can, how fast can you turn it into cash if you sell it, okay? Inventory turnover, what can we say about the inventory turnover when the inventory turnover decrease over time when you are slowing down or it's less than the industry? Well, it suggests slow moving inventory item. So this is basically, this is the first sign in my opinion when the company is going through trouble their inventory will start, it's a slow down. They are selling less and less of inventory. They're not selling the inventory as fast, okay? It could be due to obsolescence. They have old inventory, that there's no demand. It's not selling. It could be also, it could be inventory buildup because if you have too much inventory on hand, then your turnover will go down because if you have too much inventory, your turnover will slow down because you're not selling them as fast and it's an anticipation of sales increase, but that's gonna show the next period. Contractual commitment, for example, you made a commitment and you're not selling, now you have too much inventory. Also, it could be increasing in prices. Simply put, your cost is going up and as a result, you're gonna show more inventory. Work stoppage could be a reason, your inventory is not selling, inventory shortage overall or other legitimate reasons. Those are good reasons when you are auditing a company because during an audit, you look at inventory turnover and you see there's any major changes and you want an explanation and you want a reasonable explanation and you're gonna verify the explanation. So those are some possible explanation that the company might give you. For example, inventory buildup. If the inventory's slowing down and you inquire about this, they would say, oh, we just bought a large shipment by the end of the year and that's why our inventory is turnover slowed down. Now bear in mind that if you have an effective inventory management system, it increases inventory turnover. For example, if you have just-in-time system where only you order the inventory when you have a buyer, then that's good, then your inventory turnover will increase. Another related computation, actually to both inventory and receivable is something called conversion period or operating cycle. This measure combines the collection period of receivable with the days of sale, the days to sell inventories. This way will give us an idea about the time interval we convert inventory to cash. So simply put, you compute the day sales and receivable or I call it day sales in collected and let's assume for this company 75 days. And day sales and inventory, it's taken the company 75 days to 120 days to collect. Sorry, 120 days to sell, 75 days to collect. So the conversion cycle is 120. So simply put, this company buys the inventory. The inventory sits on average 120 days, then they sell it. After they sell it, it takes them 75 days to collect. So 120 plus 75 equal to 195, we call 195 the conversion period, the conversion period. And it gives you a complete picture how long it's taken the company to go from cash to cash from the time they buy the inventory until the time they sell it. Another ratio we're gonna look at, last ratio is asset turnover. It's computed by taking net sales divided by average total asset. And this tells us how efficiently asset are used to generate sales. And the best way to illustrate this point is to just use some simple numbers. If you have total sales of 1,000 and average total assets of 10,000, well, that's 10% or 0.1. What does it mean 10% or 0.1? It means for every dollar in assets, for every dollar in asset, you're generating 10 pennies in sales. For every dollar in asset, you're generating 10 pennies in sales. Now, for some industry, this asset is very high. For other industry, this asset is very low. But you cannot compare them if they're in two different industries. Let me explain. For example, a place like Walmart, place like Walmart, their sales will be, for example, I'm not gonna look them up, but I'm just gonna tell you, for example, their sales could be 300 and their asset could be only 100 because they sell a lot. Therefore, their asset turnover is three. What does that mean? It means for every dollar in asset, they're generating $3 in sales. Well, they are much, much more efficient than this company because this company is generating only 10 pennies per $1 in sales. But again, you cannot compare Walmart to, for example, a classic example, the agility store. Walmart sells a lot. A jewelry store, a place that sell jewelry does not sell as much as Walmart. Well, it's obvious. However, we're gonna see later that when it comes to profitability, Walmart has a small profit margin. So Walmart sells a lot, but their profit margin is very small versus the jewelry store here, they have a large profit margin. So the jewelry store will make up the difference even though they're not selling a lot, but whatever they sell, they make a large margin. So that's how we look at it, okay? Now, when we are computing this asset turnover, generally speaking, it's easy to, the numerator, it's easy to compare because sales is comparable between companies. But what's gonna happen is when you're looking at the denominator, when you're looking at assets, it's an issue because you're looking at total asset, at total company's asset. And what happened? When you're looking at company A versus company B, company A could have old assets reported at cost and because they are reported at cost and they're old asset, they already has been depreciated, therefore they have a low book value. So this number will be low. When you reduce assets, this increases. Just not because they are better, they are not efficient, it's their assets are old versus a company if their asset, if the book value of their asset is higher. So this number will be higher so they will have more assets on the books. As a result, this computation is gonna give them a lower asset turnover. So the point I'm trying to make here is you always have to, you always have to look into the numbers when you're computing ratios because you have to make many adjustments. Also, market value, for example, this company is buying, one company is buying bonds and they are reporting the bonds at amortized cost. Another company is buying bonds, but it's for trading. Therefore they are reported at fair value. As a result, they have more value. They have more assets. The other one, they don't show more assets. So it makes a difference how the accounting method that you are using including different inventory methods, FIFO versus LIFO. So when you're looking at a ratio like this with just a grand ratio, you just have to make many, many adjustments. So the more a ratio, like think about it this way, assets, this ratio involve all assets. Well, what we're saying is all of your assets are comparable to all of the assets of the other company. That's not true. That's the way you account for your assets will be much different because we have different accounting method then between company A, company B. So once you see a ratio that has those large numbers, you always have to slow down. Say, okay, what adjustments do I need to make to make this ratio more useful for me or more comparable, okay? And taken total assets or total liabilities and plug it into a ratio, yeah, that's, you just have to kind of slow down and see what adjustments do I need to make. If you have questions about this topic, please email me. Please visit my website for additional lectures. If you happen to visit, you can access notes, PowerPoint sites, other resources, please consider subscribing. It's an investment in your career and if you're studying for your CPA study hard, it's worth it. Good luck.