Know Accounts Receivable and Inventory Turnover

Many ratios help analysts measure how efficiently a firm is paying its bills, collecting cash from customers, and turning inventory into sales. Two of the most important are accounts receivable and inventory turnover; two ratios in the current assets category.

Accounts Receivable Turnover

Accounts receivable turnover, or A/R turnover, is calculated by dividing a firm’s sales by its accounts receivable. It is a measure of how efficiently a company is able to collect on the credit it extends to customers. A firm that is very good at collecting on its credit will have a higher accounts receivable turnover ratio. It is also important to compare a firm's ratio with that of its peers in the industry to gauge whether its ratio is on par with its industry.

Inventory Turnover

Inventory turnover is a measure of how efficiently a company turns its inventory into sales. It is calculated by taking the cost of goods sold (COGS) and dividing it by average inventory. Sometimes sales are used instead of COGS. Again, a higher number is better as it indicates that a company is quite efficient at selling off its inventory more often rather than having to store it for longer periods of time because its products are not selling.

Key Industries for Accounts Receivable Turnover and Inventory Turnover

The basic fact is that any industry that extends credit or has physical inventory will benefit from an analysis of its accounts receivable turnover and inventory turnover ratios.

Accounts receivable is primarily important when credit is extended to clients for a purchase. There are very few industries that operate only on cash; most companies have to deal with credit as well. However, certain industries may heavily favor cash. Smaller restaurants or retailers may operate under these terms. Large retailers that sell consumables, such as Walmart (WMT), Dollar General (DG), or CVS (CVS) have lower levels of receivables because many customers either pay in cash or by credit card.

Accounts receivable turnover becomes particularly important for industries where credit is extended for a long period of time. Accounts receivable turnover becomes a problem when collecting on outstanding credit is difficult or starts to take longer than expected.

One industry in which accounts receivable turnover is extremely important is in financial services. For instance, CIT Group Inc. (CIT) helps extend credit to businesses and operates a unit that specializes in factoring, which is helping other companies collect their outstanding accounts receivables. A firm can either sell its accounts receivables to CIT Group outright (CIT Group could then keep whatever debts it manages to collect), just pay CIT Group a fee for help in collections, or some combination of the two.

The client company benefits by freeing up capital, for example, if CIT pays the client company upfront cash in exchange for the accounts receivable. Selling accounts receivables, which are, after all, a current asset, can be considered a way to receive short-term financing. In some cases, it can help keep a struggling company in business.

On the inventory turnover front, a firm that doesn’t hold physical inventory is clearly going to benefit little from analyzing it. An example of a company with little to no inventory is the Internet travel firm Priceline. Priceline sells flights, hotels, and related travel services without holding any physical inventory itself. Instead, it simply collects a commission for placing these inventories on its collection of websites.

Inventory turnover measures how quickly a firm has sold and replaced its inventory over a specific period of time. Analyzing inventory turnover helps a company to make better decisions on how it prices its products, its marketing strategy and budget, its manufacturing process, and its acquisition of new inventory.

Supply Chain Management

Supply chain management consists of analyzing and improving the flow of inventory throughout a firm’s working capital system. This supply chain can be analyzed by looking at inventory in different forms, including raw materials, work in progress, and inventory that is ready for sale.

Understanding inventory and how quickly it is turned into sales is especially important in the manufacturing industry. In one survey, firms that make defense and aerospace components ranked highest in terms of having the highest inventory turnover ratios. General Dynamics (GD) has a reputation as one of the best-run firms in the industry and has reported an inventory turnover ratio in the single digits for over a decade. Auto component, automobile, and building product firms also ranked within the top 10. Machinery and metals firms also ranked highly for inventory turnover.

Putting It All Together

A measure that combines accounts receivable turnover and inventory turnover is the cash conversion cycle, which utilizes accounts payable turnover.

Taking 365 days and dividing each of these turnover ratios will convert them into a measure that can be analyzed by day in the cash conversion cycle context. It essentially measures how efficiently a company collects money from its customers and pays its suppliers for the inventory it needs to generate sales in the first place. You may note the circularity of the process, which nicely summarizes some of the key components to managing net working capital.

The Bottom Line

Accounts receivable turnover and inventory turnover are two widely used measures for analyzing how efficiently a firm is managing its current assets. Analyzing current liabilities, such as accounts payable turnover, will help capture a better picture of working capital. Generally, any firm that has receivables and inventory will benefit from a turnover analysis.