Practice of Activity Ratios

The Inventory Turnover Ratio

Measures the number of times inventory “turned over” or was converted to sales during a time
period. It may also be called the Cost of Sales to Inventory Ratio. It is a good indication of
purchasing and production efficiency. In general, the higher the ratio, the more frequently the
inventory turned over. You might expect a company with a perishable inventory, such as a
grocery store, to have a very high Inventory Turnover Ratio. Conversely, a furniture store might
have a low Inventory Turnover Ratio.

Inventory Turnover = Cost of Goods Sold/Average Inventory

Inventory turnover in Days

Once you have calculated the Inventory Turnover Ratio, you can convert it to the actual number
of days of inventory you have on hand. This key ratio combined with the Accounts Receivable
Days on Hand and Accounts Payable Days convert to what is called the Cash Cycle.
This is a ratio you will definitely want to compare to industry standards. Keep in mind, its
significance depends on the amount of cash sales a company has. For a company without many
cash sales, it may not be important. Also, it is a measure at only one point in time and does not
take into account seasonal fluctuations.

Inventory Turnover in Days = Average Inventory/Cost of Goods Sold*365

Days’ Sales in Inventory

The number of days’ sales in inventory ratio relates the amount of the ending inventory to the
average daily cost of goods sold. All of the inventory accounts should be included in the
computation. The computation gives an indication of the length of time that it will take to use up
the inventory through sales. This can be misleading if sales are seasonal or if the company uses a
natural business year. If the company uses a natural business year for its accounting period, the
number of days’ sales in inventory will tend to be understated because the average daily cost of
goods sold will be at a low point at this time of year. If the days’ sales in inventory is
understated, the liquidity of the inventory is overstated. The same caution should be observed
here as was suggested for determining the liquidity of receivables, when one company uses a
natural business year and the other uses a calendar year.
If the company closes its year during peak activity, the number of days’ sales in inventory would
tend to be overstated and the liquidity would be understated. As indicated with receivables, no
good business reason exists for closing the year when activities are at a peak, so this situation
should rarely occur. Compute the number of days’ sales in inventory as follows:

Days’ Sales in Inventory = Ending Inventory/Cost of Goods Sold*365

Accounts Receivable Turnover Ratio

The Accounts Receivable Turnover Ratio measures the number of time accounts receivable
turned over during a time period. A higher ratio indicates a shorter time between making a sale
and collecting the cash.

Accounts Receivable Turnover = Net Sales/Average Gross Receivables

Accounts Receivable Turnover in Days/on Hand

When you have calculated your Accounts Receivable Turnover Ratio, you can convert it to the
actual number of days accounts receivable are outstanding. The goal as a business is to keep the
number of days your accounts receivable are outstanding as low as possible. After all, you need
the cash to build your company, not finance your customers.

Accounts Receivable Turnover in Days = Average Gross Receivables/Net Sales*365

Days’ Sales in Receivables

The number of days’ sales in receivables relates the amount of the accounts receivable to the
average daily sales on account. For this computation, the accounts receivable amount should
include trade notes receivable. Other receivables not related to sales on account should not be
included in this computation. Compute the days’ sales in receivables as follows:

Days’ Sales in Receivables = Gross Receivables/Net Sales*365

Operating Cycle
The operating cycle represents the period of time elapsing between the acquisition of goods and
the final cash realization resulting from sales and subsequent collections. An approximation of
the operating cycle can be determined from the receivables liquidity figures and the inventory
liquidity figures. Compute the operating cycle as follows:

Operating Cycle = Accounts Receivable Turnover in Days + Inventory Turnover in Days

Cash Cycle
Once you have calculated the number of days in Accounts Receivable, Inventory and Accounts
Payable for your company, you can use them to calculate your Cash Cycle.
The Cash Cycle is sometimes referred to as the Trading Cycle or the Cash Conversion Cycle and
measures the time in days it takes to acquire and sell inventory and convert sales to cash. It
measures your effectiveness as manager of this process

Cash Cycle = Accounts Receivable Days + Inventory Days – Accounts Payable Days

These three steps, purchasing inventory, selling inventory and collecting accounts receivable are
critical to the cash flow and profitability of your company. You, and only you, as the business
owner have the ability to affect change in this number. You are responsible for directing how
each of the steps is managed to maximize your return.

Question # 1: The following average receivable and sales data for the year 2016 for
Shahtaj Sugar Mills are given below:
Years 2002 2003 2004 2005
Sales 17,000 14,580 9,600 9000
Average accounts 1,700 1,620 1,600 1,800
Receivable
Required: Calculate receivable turn over and receivable turn over in days and give your
expert opinion regarding:

1. Performance of collection department from year 2002 to 2005.

2. Change in the collection trends from year 2002 to 2005.
Question # 2: The following inventory and receivable and sales data for the year 2016
for Ashraf Company are given below:
End of Year Beginning of Year
Net Sales 31,50,000
Gross receivables 180,000 160,000
Inventory 480,000 390,000
Cost of goods sold 22,50,000
Required:
1. the account receivable turnover in days
2. the inventory turnover in days

Question # 3: Following data has been provided for shahzan international limited for the year
1986 to 1987.

1987 1986
Cost of Goods Sold 786,523 700,263
Inventories:
Opening (january 1) 173,999 167,286
Closing (december 31) 195,512 173,999
Total 369,511 341,285
Net Sales 1,086,944 988,417
Working Capital:
Opening (january 1) 241,952 217,848
Closing (december 31) 266,586 241,952
Total 508538 459800

Required: You are required to calculate the following and comment on the activity ratios of
the company.
(1) Inventory Turnover
(2) Number of Days Sales in Inventory
(3) Working Capital Turnover
(4) Number of Days Sales invested in Working Capital

Question # 4: From the Account of Arnold Ltd. For the year ended 31-12-2001

Sales 125,000
Opening Stock 20,000
Purchases on Credit 110,000
Gross profit 25,000
Expenses 15,000

Fixed Assets 76,000

Current Assets (Including Debtors $25,000) 66,000
Liquid Assets 36,000
Current Liabilities ( Creditors only) 22,000
Ordinary Shares 80,000
8% Cumulative preference shares 30,000
Capital Employed 120,000

Required: You are required to Calculate the following Figures and Ratios:
1-- (a)Figure of Cost of Goods Sold, (b) Closing Stock
2-- The Period of Credit Given to Debtors
3-- The Period of Credit Received from Creditors
4--The Rate of Stock Turnover

Question # 5: Presented below are selected data for two years ending December 31st for
Suleman Ltd. Year1 Year2
Net Sales 10,50,000 10,00,000
Average total Assets 230,000 200,000

Required: You are required to calculate total asset turnover from year1 to 2.

Question # 6:
Years 2005 2004 2003 2002
Cost of goods sold 17,000 14,580 9,600 9000
Average stock 1,700 1,620 1,600 1,800

Required:
1. What do you mean by inventory turnover, how entity can suffer from bad
management of Inventory?
2. Calculate inventory turnover and inventory turnover in days also comment on the
trends.
Question # 7: The following financial data was taken from the financial annual statements of the
smith corporation:
2009 2010 2011
Sales 1,450,000 1,500,000 1,400,000
 COGS 1,180,000 1,020,000 1,120,000
Inventory 280,000 200,000 250,000
Accounts receivable 120,000 110,000 105,000

Required: Based on the data given above calculate the following for the year 2010 and 2011.
1. Accounts receivable turnover
2. Accounts receivable turnover in days
3. Inventory turnover.
4. Inventory turnover in days.

Question # 8: From the following annual accounts of New Horizontal Limited.

Extracts from balance sheet on 31st Dec, 2007

Stocks 310,000
Debtors 770,000
Extracts from years profit and loss account
Sales for the year 31,00,000
Gross profit 17,25,000
Expenses 8,05,000
Depreciation 2,50,000
Required: you are required to calculate the following ratios and comment on the results
(i) Debtors turnover,
(ii) Debtors collection period,
(iii) Cost of goods sold,
(iv)Stock turnover,

Question # 9: Hawk Company wants to determine the liquidity of its receivables. It has supplied
you with the following data regarding selected accounts for December 31, 2011, and 2010:

2011 2010
Net sales $1,180,178 $2,200,000
Receivables, less allowance for losses and discounts
Beginning of year (allowance for losses and
discounts, 2011—$12,300; 2010—$7,180) 240,360 230,180
End of year (allowance for losses and discounts,
2011—$11,180; 2010—$12,300) 220,385 240,360

Required:
a. Compute the number of days’ sales in receivables at December 31, 2011, and 2010.
b. Compute the accounts receivable turnover for 2011 and 2010. (Use year-end gross
receivables and comment on the liquidity of Hawk Company receivables.
Question # 10: Haward Company wants to determine the liquidity of its receivables. It has
supplied you with the following data regarding selected accounts for December 31, 2007, and
2006:
2007 2006
Net sales $2,180,178 $2,300,000
Receivables, less allowance for losses and discounts
Beginning of year (allowance for losses and
discounts, 2007—$12,300; 2006—$7,180) 640,360 530,180
End of year (allowance for losses and
discounts, 2007—$11,180; 2006—$12,300) 620,385 540,360
Required:
a. Compute the number of days’ sales in receivables at December 31, 2007, and 2006.
b. Compute the accounts receivable turnover for 2007 and 2006. (Use year-end gross
receivables.)

Question # 11:
A partial balance sheet and income statement for King Corporation follow:
KING CORPORATION
Partial Balance Sheet
December 31, 2017
Assets
Current assets:
Trade receivables 255,000
Inventories 523,000
Liabilities
Current liabilities:
Trade accounts payable $ 103,689
Notes payable 210,381
Accrued expenses and other liabilities 120,602

KING CORPORATION
Partial Income Statement
For Year Ended December 31, 2017
Net sales $3,050,600
Miscellaneous income 45,060
$3,095,660
Costs and expenses:
Cost of sales $2,185,100
Selling, general, and administrative expenses 350,265
Interest expense 45,600
Income taxes 300,000
2,880,965
Net income $ 214,695
Note: The trade receivables at December 31, 2016, were $280,000. The inventory at December
31, 2016, was $565,000.
Required Compute the following:
1. Account receivables turnover
2. Accounts receivable turnover in days
3. Inventory turnover
4. Inventory turnover in days
5. Operating cycle