Analyzing a company's inventories and receivables is a reliable way to determine whether it is a good investment play. Companies stay efficient and competitive by keeping inventory down and speeding up the collection of what they're owed.
Efficiency ratios determine how productively a company manages its assets and liabilities to maximize profits. Shareholders look at these ratios to assess how effectively their investments in the company are being used. Some of the most commonly considered efficiency ratios include inventory turnover, accounts receivable turnover, accounts payable turnover, and the cash conversion cycle.
Key Takeaways
- Inventories and receivables can help investors and analysts determine whether companies are good investments.
- You can use efficiency ratios to determine how productive a company is when it comes to managing its assets and liabilities.
- The inventory turnover ratio accounts for how well a company gets its goods off the shelves.
- A company's accounts receivable and accounts payable ratio indicate how well a company collects and pays its debts.
- The cash conversion cycle provides a complete summary of how well a company manages its cash inflows and outflows.
Inventory Turnover Ratio
Getting Goods off the Shelf
As an investor, you want to know if a company has too much money tied up in its inventory. Companies have limited funds to invest in inventory, which means they can't stock a lifetime supply of every item. To generate the cash to pay bills and return a profit, they must sell any of their products. Inventory turnover measures how quickly the company moves merchandise through the warehouse to customers.
The inventory turnover ratio gives an indication of how many times a company sells and restocks its inventory over a given period or how many days on average it takes the company to sell out its inventory. Higher inventory turnover rates are generally considered favorable, which indicates brisk sales. Excessively frequent turnover may indicate inefficient ordering or that a company may have difficulty meeting timely demands for orders.
Let's take a look at Walmart. The company is known for its efficient operations and supply chain system, which keeps inventories at a bare minimum. In fiscal 2023, inventory sat on its shelves for an average of 44 days (we explain the calculation below). Like most companies, Walmart doesn't provide inventory turnover numbers to investors, but they can be flushed out using data from Walmart's financial statements.
Inventory Days = 365 Days÷(ACOGS÷AI)where:ACOGS = Average cost of goods soldAI = Average inventory
- Obtaining Average COGS: To get the necessary data, find its consolidated statements of income on the company's website and locate the cost of goods sold (COGS), which is also referred to as the cost of sales. You can find this just below the top-line sales or revenue. For the 2023 fiscal year, Walmart's COGS totaled $463.72 billion.
- Obtaining Average Inventory: Then look at the consolidated balance sheet. You'll find the inventory figure under the assets section. In 2023, Walmart's inventory was $56.58 billion, and in 2022, it was $56.51 billion. Average the two numbers ($56.58 billion + $56.51 billion ÷ 2 = $56.54 billion), then divide the result into the average COGS in 2023. You will arrive at the annual turnover ratio of 8.2. Now, divide the number of days in the year, 365, by the annual turnover ratio. We end up with 44.5. That means it takes Walmart about 44 days, or a month and a half, to cycle through its inventory. This number of inventory days is also known as the days-to-sell or days sales of inventory ratio (DSI).
Fewer days mean a company is more efficient—inventory is held for less time and less money is tied up. Money can be used for things like research and development (R&D), marketing, share buybacks, and dividend payments. Conversely, sales may be poor and inventory may pile up if the number of days is high.
Special Considerations
Investors need to know if the days-to-sell inventory figure is getting better or worse over several periods. To get a decent sense of the trend, calculate at least two years' worth of quarterly inventory sales numbers.
If you spot an obvious trend in the numbers, ask why. Investors would be pleased if the number of inventory days decreased because of greater efficiencies gained through tighter inventory controls. On the other hand, products may be moving off the shelf more quickly simply because the company is cutting its prices.
To get an answer, flip to the income statement and look at Walmart's gross margin (top-line revenue or net sales minus cost of sales). Check to see whether gross margins as a percentage of revenue/net sales are on an upward or downward trajectory:
- Consistent or rising gross margins offer an encouraging sign of improved efficiencies.
- Shrinking margins, on the other hand, suggest the company is resorting to price cuts to boost sales.
Walmart's gross margins, expressed as a percentage of net sales, dropped between 2023 and 2022. Remember that:
Gross Margin = ((Net Sales - COGS or Cost of Net Sales) ÷ Net Sales) x 100
So we can calculate the company's gross margins for both years:
- 2023: (($605.88 billion - $463.72 billion) ÷ $605.88 billion) x 100) = 23.5%
- 2022: (($567.76 billion - $429 billion) ÷ $$567.76 billion) x 100 = 24.4%
An increase in inventory days isn't necessarily a bad thing. Companies normally let inventories build up when they introduce a new product in the market or ahead of a busy sales period. However, if you don't foresee an obvious pick-up in demand coming, the increase could mean that unsold goods will simply collect dust in the stockroom.
Accounts Receivable Turnover Ratio
Accounts receivable (AR) is the money owed to a company by its customers. Analyzing how quickly a company collects what is due can tell you a lot about its financial efficiency. A longer collection period could spell out problems in the future. The company may allow its customers to stretch their credit to recognize greater top-line sales and that can spell trouble later on, especially if customers face a cash crunch.
Getting money right away is better than waiting for it, especially since some of what is owed may never be paid. The quicker a company gets its customers to make payments, the sooner it can pay for merchandise and equipment, salaries, and loans as well as dividends and growth opportunities.
The AR turnover ratio indicates how efficiently a company is at collecting sales revenues on a timely basis. Companies using payment terms of 30 to 60 days and being paid on time yield accounts receivable turnover ratios between 6 and 12. Low ratios can indicate payment-collection problems. Investors should determine the average number of days the company takes to collect its accounts receivable. Here is the formula:
Receivables Days = 365 Days÷(Revenues÷AR)where:AR = Average receivables
On the top of the income statement, you will find revenues. On the balance sheet under current assets, you will find accounts receivable. Walmart generated $605.88 billion in net sales in 2023. At the end of that year, its accounts receivable stood at $7.93 billion, and in 2010, it was $8.28 billion, yielding an average accounts receivable figure of about $8 billion.
Dividing revenue by average receivables gives a receivables turnover ratio of 76. This shows how many times the company turned over its receivables in the annual period. Using the formula above, we get an average turnover rate of under five days, which means it took about a week for Walmart to receive payment for the goods it sold.
Accounts Payable Turnover Ratio
The accounts payable turnover ratio is a short-term liquidity metric that gauges how efficiently a company manages its outflows of cash, especially in relation to paying its creditors.
Higher ratios, indicating the company can keep cash on hand longer, are generally considered preferable. However, a company must balance this with maintaining good credit and avoiding late payment fees.
Cash Conversion Cycle
The cash conversion cycle combines the measurements of inventory, accounts receivable, and accounts payable turnover rates to give a more complete summary of a company's overall proficiency at managing its inflows and outflows of cash.
A faster CCC shows better cash management. If a company's CCC is problematically slow, the problem can usually be identified within days of inventory outstanding, days receivable outstanding, or days payable outstanding.
These efficiency measures apply largely to companies that make or sell goods. Software companies and firms that sell intellectual property as well as many service companies do not carry inventory as part of their day-to-day business, so the inventory days' metric is of little value when analyzing these kinds of companies. However, you can certainly use the days' receivables formula to examine how efficiently these companies collect what's owed.
Sizing up Efficiencies
It's good news when you see shorter inventory days and a narrower collection period. Still, that's not enough to fully understand how a company is running. To gauge real efficiency, you need to see how the company stacks up against other industry players.
Let's see how Walmart compared in 2003 to rival Target. Target's sales for 2023 were $105.8 billion while its inventory totaled $11.88 billion for 2023 and $13.5 for 2022. The company reported its total cost of sales of $77.74 billion for 2023 and $82.23 billion for 2022. In 2023, the company's accounts receivable totaled $1.7 billion and $1.35 billion in 2022.
- Walmart turned its inventory over an average of 44 days while Target's inventory turnover took nearly 43 days
- Walmart collected payments in under five days, but Target relied heavily on slow-to-collect credit card revenues and required almost 5.3 days to get its money.
As Walmart shows, using competitors as a benchmark can enhance investors' sense of a company's real efficiency.
Comparative numbers can be deceiving if investors don't do enough research. Just because one firm's numbers are lower than a rival's, doesn't mean that one firm will have a more efficient performance. Business models and product mix need to be taken into account. Inventory cycles differ from industry to industry.
Is Efficiency the Same as Effectiveness?
No, the two concepts are different—especially in business. Efficiency refers to the way things are done to reduce or minimize efforts and costs. A business runs efficiently when it puts as little money and effort as possible to create its products and services. Effectiveness, on the other hand, is the ability of a company to achieve its business goals as per its vision while maximizing revenue.
What Are Accounts Receivable?
Accounts receivable represents the money owed to a company by its customers for goods and services delivered. AR is considered a current asset and is listed on a company's balance sheet.
What Is Business Inventory?
The term business inventory refers to all of the items a company has to sell so it can make a profit. These items include finished goods, services, merchandise, and any other materials it has on hand. The general rule is that companies do well when they sell their inventory faster. Keeping inventory on the shelves can be a problem because goods tend to lose value over time and storage costs continue to build up.
The Bottom Line
Finding out where a firm's cash is tied up can help shed light on how efficiently a company is being managed, utilizes its assets, and handles liabilities. It takes time and effort to extract the information from corporate financial statements. However, doing the analysis will certainly help you find which companies are worthy of investment. Just bear in mind that having one or several high-efficiency ratios does not necessarily mean a company is making money. Efficiency ratios can indicate profitability, but even though a company may be well-managed and operating efficiently, it does not automatically translate into turning a profit.