What are working capital ratios?

What is working capital ratios and why should I care?

Working capital refers to the timing difference between when a sale is made or a cost incurred versus when the cash actually leaves the company's bank account. If you hear someone talking about working capital, they're simply referring to a company's normal operating cash.

Working capital ratios help an investor to assess how good the company is at generating cash. For example, a company may make all the sales it likes but if it never actually collects the cash then it's a lousy investment. Working capital ratios help us to compare different businesses in terms of their ability to generate cash.

How to calculate receivables days and payables days?

Sometimes called debtor days and creditor days these are really easy to understand and to calculate. Receivables days refers to the number of days on average that the business takes to collect the money made from its sales to customers. Payables days refers to the number of days on average that the business on average takes to pay its suppliers for costs incurred.

Receivables days are calculated as the total money owed to the business (i.e. Receivables) by customers divided by total sales multiplied by 365 days. Simply: receivables / sales * 365.

Payables days are calculated as the total money owed by the business (i.e. Payables) to its suppliers divided by total costs multiplied by 365 days. Simply: receivables / sales * 365.

Primarily an investor is interested in businesses that are able to reduce the amount of receivables days and increase the amount of payables days. Bear in mind that some industries naturally lend themselves to certain types of receivables/payables days. For example, a shop will naturally have very low receivables days as it normally takes cash upfront from customers.

What are stock days?

Stock days, sometimes known as industry days are a type of working capital ratio that measures the convertibility of a company's stock into cash. The longer a company sits on its inventory and stores it in a warehouse, thus the longer the stock days. Ideally, you are looking for a business that is able to minimise its inventory days as it is a good indicator that they aren't sat on large amounts of obsolete stock.

Stock days are easily calculated as the value of inventory as found on the balance sheet divided by the cost of sales for the year multiplied by 365. Simply: inventory / cost of sales * 365.

What is asset turnover?

Finally, asset turnover is used as a measure of a company's efficient use of its assets. It asks the question: how good is the company at producing revenue from each £1 of assets?

Asset turnover is calculated as the company's sales divided by its assets. The produces either a ratio, decimal or percentage answer. The higher the percentage the more efficient the assets are at producing revenue and hence the better the efficiency of the company, the more attractive the business is as an investment prospect.

Do you like what you've read? Tell your friends by sharing it with one of the buttons below. Please post this to Facebook or Tweet it to help your friends and family. Feel free to send me an email (mrmoneybanks@multimillionaireroad.com), find me on twitter @millionairer0ad or comment. Whether good or bad, I want to hear from you all.

No comments