I began this series, in my mind, in late 2007 when Conrad Carlberg asked me to assist him in writing a textbook for QuickBooks users on Business Analysis. At the time I recognized that most 'typical users' would never read the book, but I felt that it would be an excellent resource by which QuickBooks ProAdvisors and other business consultants could expand not only their knowledge of essential business analytics and datametrics, but potentially expand their practice offerings as well.
With the inclusion of 'Advisory Services' within the curriculum for the Advanced QuickBooks Online Certification released in the fall of 2014, which included some basic business analysis concepts including financial ratios, I decided it was time to do a short series of articles feature some of the details included in Business Analysis for QuickBooks with some updates to remain consistent with the certification reference as well.
This is the final part of a four part series. In part one of this series we looked at Profitability Ratios, in part two we looked at Liquidity ratios, in part three we looked at solvency or leverage ratios and in this article we will examine the two most common Efficiency and Activity Ratio analytics and their corresponding datametrics.
Efficiency and Activity Ratios
Efficiency Ratios are used to analyze how a business is using its assets and liabilities internally. Efficiency Ratios can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity and the general use of inventory and machinery. Efficiency Ratios go hand in hand with Activity Ratios that measure the efficiency of a business based on the use of its assets, leverage or other such balance sheet items. These ratios also help determine how a business is doing at generating revenues, cash, etc. from its resources.
Ratios that measure the frequency of inventory turnover and how log invoices remain unpaid are important measures of how efficiently a business progresses through the sales cycle.
A/R Turnover Ratio and
Average Collection Period/Rate
The Accounts Receivable turnover ratio is an activity ratio, measuring how efficiently a business uses its assets. This analytic is defined as:
The corresponding datametric measures the Average Collection Period or average collection rate. If you have made $500,000 in net sales for a year and your average monthly A/R balance was $50,000 during that year, you are turning over at the rate of ten times per year, so your average collection period is 36.5 days (365/10 = 36.5). This calculation is a rough estimate at best because it depends on the comparison of credit sales made during one period with the collection of accounts receivable made at other times. It’s a complex task to get truly comparative data from QuickBooks, this is why many of the automated utilities that compute financials ratios can provide more accurate analysis.
A high A/R Turnover Ratio implies either that a business is operating on a cash basis or that the company is making wise decisions in the extension of credit to its customers or the business has efficient A/R collection efforts. On the other hand, a low A/R Turnover Ratio indicates the business is either making risky decisions in extending credit to its customers or it is not timely or efficiently collecting accounts receivable that are due.
Inventory Turns Ratio
The ‘Turns Ratio’, also known as the Inventory Turnover Ratio, indicates how many times a company's inventory is sold and replaced over a given period. This analytic is
This dollar valued ratio is handy because it’s possible to compare turns ratios across items, or product lines, even companies. The Inventory Turnover Ratio should be compared against comparative company averages, this is another reason why many financial analytic products can both produce and analyze the data more efficiently that you can do using complex manual methods.
Low Inventory Turnover indicates poor sales and accordingly, excess inventory on hand. A high Inventory Turnover ratio indicates either robust sales or ineffective purchasing. High inventory levels are unhealthy because they represent an investment with a zero rate of return. It also places a business at risk should prices begin to fall.
The corresponding datametric is calculated when the days in the period are divided by the inventory turnover to calculate the days it takes to sell the inventory on hand, the measure is referred to as "inventory turnover days."
Business analysis is a valuable management tool that can improve your understanding of the financial results and trends of a business over time. Ratios provide key indicators of organizational performance. Business Owners and Managers can use ratio analysis to pinpoint strengths and weaknesses from which business strategies and initiatives can be formulated. Lenders typically use a variety of ratio analyses to measure the results of a particular business against other similar companies in order to make decisions concerning financing that can have a major impact upon a company's mission.
ProAdvisors and other Business Consultants need to have an understanding of these critical measures. While modern software programs compute these analytics and datametrics in seconds (as opposed to manual computations in days of old) it is still essential that those using such data have a knowledge of the principles and fundamentals of these ratios such that the 'numbers' remain true to their origin.
Always remember, for financial ratios to be useful and meaningful, they must be:
- Calculated using reliable, accurate financial information
- Calculated consistently from one period to the next period
- Compared against internal benchmarks and goals
- Compared to industry averages and/or other similar companies
- Interpreted at any single point in time as solely an indicator of broader trends and issues over time
- Interpreted carefully in their proper context, considering all of the other important factors and indicators appropriate to assessing overall performance.
Best of luck in your business analysis.
Business Analysis for QuickBooks, Conrad Carlberg, Author, William “Bill” Murphy, Technical Editor; Wiley Publishing, 2009.
QuickBooks Online Advanced Certification Course Supplemental Guide – Module 5: Advisory Services; Michelle L. Long, Author; Intuit, Inc., 2014.