Operating performance ratios
/Operating performance ratios are intended to measure different aspects of an organization's core operations. The focus of these measurements is on the efficient use of resources to generate sales, as well as how well assets can be converted into cash. A business with excellent performance ratios can generate a high level of sales with relatively few resources, and generates a high level of cash inflows. The essential operating performance measurements are noted below.
Operating Cycle
The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. A company with an extremely short operating cycle requires less cash to maintain its operations and so can still grow while selling at relatively small margins. Conversely, a business may have fat margins and yet still require additional financing to grow at even a modest pace, if its operating cycle is unusually long. Subsets of the operating cycle can be examined by reviewing accounts receivable turnover, inventory turnover, and accounts payable turnover.
To keep the operating cycle short, managers tend to focus on collecting receivables as soon as possible, maintaining low inventory levels, and paying suppliers as late as possible.
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Cash Conversion Cycle
The cash conversion cycle measures the time period required to convert resources into cash. The intent behind the measurement is to determine how long invested funds are tied up in the production and sales processes. A short duration cash conversion cycle allows a business to be operated with a smaller up-front cash investment. The factors used to derive the cash conversion cycle are as follows:
The average time required to pay supplier invoices
The average time required to convert raw materials into finished goods
The average time required to collect receivables from customers
The Cash Conversion Cycle Formula
The cash conversion cycle formula is as follows:
Days inventory outstanding + Days sales outstanding - Days payables outstanding = Cash conversion cycle
The calculation of the various components of the cash conversion cycle are as follows:
Days inventory outstanding = (Average inventory ÷ Cost of goods sold) x 365 Days
Days sales outstanding = (Accounts receivable ÷ Annual revenue) × Number of days in the year
Days payables outstanding = Ending accounts payable ÷ (Cost of sales ÷ Number of days)
Fixed Asset Turnover
Fixed asset turnover compares revenues to net fixed assets. A high ratio indicates that a business is generating a large amount of sales from a relatively small fixed asset base. The formula is net sales divided by net fixed assets. The ratio can yield false results if a business is using very old assets to generate sales; at some point, those assets must be replaced. The measurement is less useful in a services business, which tends to operate with few fixed assets. The formula is:
Net annual sales ÷ (Gross fixed assets - Accumulated depreciation) = Fixed asset turnover
Sales per Employee
Sales per employee compares revenues to the number of employees. A high ratio indicates that a business is creating a large volume of sales with very few employees. The formula is net sales divided by the number of full time equivalents. The ratio can yield false results if a business is outsourcing a large amount of work or using a large number of contractors. The measurement tends to be relatively low for services businesses, where sales are generated from billable employee hours. The formula is:
Annualized net sales ÷ Total full-time equivalents = Sales per employee