 Hello and welcome to this session in which we would look at the activity ratios. This is part four of seven of the financial statement analysis series. In part one, we looked at the introduction to the financial statement analysis. In part two, we looked at horizontal, vertical and common size financial statement. Part three, we looked at the liquidity ratios. And in this session, we would look at activity ratios. Activity ratios measures how efficiently and how effectively assets are being used. Now, why is that important for accountant, auditor, analyst? Well, we have to know how efficient or how effectively from an investor's perspective, before we invest in a company, the company is using their assets. Now, from an auditor's perspective, studying those ratios will help you determine if something is out of whack. Something does not make any sense. Or if it's a red flag area where it needs further work. And we would look at it when we look at actual numbers. We would explain this concept a little bit better. So what I'm going to do now, I'm going to switch to the Excel sheet using the same figures that we use for the prior session illustrating activity ratios. So this is the balance sheet we're going to be working with, as well as the income statement and those financial statements, they can be downloaded from farhatlectures.com from my website. Starting with activity ratios, we're going to be looking at account receivable turnover. Well, how do we compute account receivable turnover? We're going to take net sales divided by the average account receivable. The first thing you need to ask yourself is why am I dividing it by the average? Well, net sales is an income statement account. It's for a period of time. The income statement figures are for a period of time. Account receivable is a balance sheet account. If you divide net sales by ending account receivable, you are dividing it by the end of the year, one point in time versus the income statement is a period of time. Therefore, to compensate, you're going to have to take the beginning account receivable plus the ending receivable dividing by two. And this way, you have an equivalent denominator to the numerator because the numerator is for a period of time. Therefore, if we look at the figures here, if we take 2,250 divided by the average account receivable, simply put, if we go to the balance sheet here, here are the receivable and what we did is we take year one plus year two divided by two, we come up with a figure of 5.28. What does this figure mean? Well, it means you sell and collect your receivable 5.8 times per year. So if this is the year, so 1, 2, 3, 4, 5.28. What does that mean? Well, that means you sell, you collect your money, you sell again, you collect your money, you sell again, you collect your money, 5.8. Now, do you want this to be high or low? Well, you want the turnover to be high. You want to be selling and collecting your money as fast as possible. Well, is this a good number, a bad number? Remember, in ratios you really don't know. You really don't know why because you have to compare 5.28 to prior periods. See, in the prior period, are you doing better or worse? Or you have to compare yourself to A to a competitor. Now, from an auditor's perspective, when you look at 5.28 and last year was 6, let's assume it was 4, 4.0. Well, one of two things happen. Well, they're collecting their money faster or they're selling less on account or a combination of these two. Well, you need to see if that makes sense or not because now went from 4 to 5.28. Now, to translate this into how many days on average, we're going to take 365, which is the number of days of the year divided by account receivable turnover. Now, certain tax book, they use 360 days. We're going to be using 365. Again, this is the number of days in a year divided by the account receivable turnover. It means it takes on average 70 days to collect your money. Simply put, you sell, 70 days later, you collect, you sell again. So each one of these semi-circles is 70 days. So again, is this good or not good? We really cannot answer. We have to look at, put it into perspective. Now, obviously, average collection period, you want it to be low. Now, typically, 30 days is a good thing and lower is better. So the average collection period, the lower, the better. Why? Because it means you are collecting your money earlier. The sooner you can collect money, the sooner you have that cash for other activities. Again, from an auditor's perspective, if this number fluctuates a lot from year to year, well, you need to find out what's going, it's either has to do with sales or account receivable. And you have to understand that this is unusual because they should have a relationship between two. There should be a predictable relationship. So before you start, you start auditing the company, if you think it should be 5.28 and you computed it and it's 5.28 or approximately 5.35 or something like that, close enough, well, it seems it's as predicted. You stole the work, but it's as predicted. But if you computed it and it's much higher or much lower, then there's more work to do. This is how you manage your receivable. Another asset that we can measure is inventory turnover. How well you manage your inventory? How do we compute this? We take cost of goods sold, which is an income statement account. And guess what? We're going to divide it by average inventory. Why? Because the numerator is an income statement account. And if we compute it, we find out it's 4.15. What does that mean? It means you buy, you sell, you sell all of your inventory, 4.15 a year, 1, 2, 3, 4, 4.15. So you buy, you fill out your shop, you sell it, you sell all, you do this 4.15 a year. Now let's translate this into how many days we'll take 365 divided by inventory turnover. Now we want the turnover to be as high as possible. We want it to turn over as many times by the inventory, then sell it, buy it, and sell it, so on and so forth. But to measure that, we'll take 365 divided by inventory turnover. It looks, you're selling your inventory every 88 days, 87.99. We're going to say 88. And for this, we're going to go with 69. 69 days to collect your money, 88 days to sell. Now you want the day sales and inventory as low as possible. For example, a company like Apple, they have, at some point, they had seven to 10 days. I'm not sure what's the latest for them, but around seven to 10 days, they sell their inventory. So if you go to an Apple store, you go and you walk inside, you look at everything on the shelves. On average, when you come back a week later, week to 10 days, everything that's in that store was already sold and replaced. So they turn over their inventory very quickly, and that's what you want. So let's do a quick exercise to show you what I mean by if it's out of the north. Let's assume you expect the ratio to be 4.15 and it was 4.15. But let's assume the inventory for the company was rather than 321. When you computed the inventory, it was one, let's make it 110 just for the sake of illustration. Now what's going to happen to the ratio? It went up to 6.38. Well, we said it should be around 4.2 to 4.3. And now their inventory turned over to 6.38. Well, they should not be selling their inventory this fast. Well, it could be that they're understating their inventory. That could be a reason why this happens. They are understating their inventory. That could be the reason. So that's why the ratios, they help us understand if there is something unusual with the company. There's something unusual. That's how it helps auditors. Accounts payable turn over. We're going to take cost of goods sold divided by again average accounts payable. In other words, it's going to tell us how long it's taking for us to pay our payable. Well, we pay our payable basically the same concept 7.7 times a year or on average every 47 days, we send a check for our payable. Again, is this a good thing, a bad thing? Well, maybe that's the norm in the industry. Maybe this is our relationship with our creditors. It takes us a month and a half. We pay them every 45 days. Maybe that's the norm or it may not be. Maybe they want us to pay early or maybe the norm is 60 and it's a month and a half. Regardless, we have to put it into perspective. Now taking those three ratios together, we can compute something called the operating cycle. And the operating cycle is taking days and a count receivable or average of receivable, which is this number here, average collection period plus days and inventory. And that's going to give us 157.1 days. What does that mean operating cycle? It means from the time we buy the inventory until we sell it, it takes us 87 days. So if this is 0.0, we buy the inventory 88 days later, we sell it. After we sell it, it will take us an additional 69 days to collect the money. So those two together, 88 plus 69, that's going to give us 157 days. This is called the operating cycle from the time we buy the product until the time we sell it. Now there's another formula that we need to be aware of. Sometimes you get asked about is called the cash conversion cycle. The cash conversion cycle is basically taking the operating cycle and deducting from the operating cycle days and accounts payable. And the days and accounts payable, we pay every 47 days. Now what does that mean? It means the cash conversion cycle is 110 days. Let me show you on a timeline how this all looks like so it makes sense to you. The way you compute it is average receivable collection period plus days and inventory. This is the operating minus days sales and AP. Well, this is day zero. You buy the inventory and you have to pay it 47 days later. You have to pay here. So you have to pay right here after 47 days because this is how long it's taken us. Then at that point, we did not sell anything. By that point, it's going to take us up until day 88 until we sell. What does that mean? It means after we pay for it, after we pay for it, but took us the inventory set on the shelves for 41 days and we really did not do, we could do anything just waiting after we paid for it. That's a long time, but it could be in some industries. Then after we sell it, it took us 69 days until we collect the money, until we collect the money. Now, let's think about it. So what does that mean? It means this period here, let me just use a different color, 41 and 69. If you take 41 plus 69 will give us 100 and approximately 110 days, 110 days. So our cash conversion cycle from the time we pay until the time we collect this money is 110. Now, we want this to be as small as possible because think about it. On day 47 and day 47, we pay. Then it took us another 110 days to collect that money because we needed 41 days to sell it and 69 days to collect. Again, this is really skewed in favor of the supplier because the supplier get their money and it's going to take us 110 days to sell and get our money back. But again, it could be a product, could be the norm. For example, as I told you in the prior session, Walmart will have a shorter. Basically Walmart will make the supplier wait for their money. It's the opposite, but that's the point. So to compute it, you will take average account, how many days it's taken you to collect plus how many days it's taken you to sell minus days and accounts payable. Why? Because days and accounts payable, it's they're waiting to be paid. Therefore, you're going to deduct this. You're going to deduct this 47 days from the whole time, from the 157, from your operating cycle. I hope this makes sense. Last but not least is the asset turnover or total asset turnover. This is another efficiency ratio and it's selling us on average. How efficient are we using our total asset to generate sales? How do we compute this? We'll take sales and we'll divide sales by average total asset. Again, why average? Because sales is an income statement number. And here it gives us 0.76. What does that mean? It means for every dollar in assets we have, we are generating 76 pennies in sales. For every dollar in assets, we are generating 76 pennies. Are we efficient? Not efficient? Does this make sense? As an auditor, you might have some expectation before you start the audit that for this industry, it should be 0.6. Why is it 0.76? Are they increasing their sales or do they have less asset? Are they being more efficient? Or is it a combination of these two? 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