Evaluating Business Performance - Liquidity Flashcards
Accounts Payable Turnover - formula, what it measures and the benchmarks used to assess?
It measures: the average number of days it tasks for a business to pay its Accounts Payable.
Benchmarks:
- Past Performance (trend analysis)
- Budgeted Performance
- Industry Average
- Credit Terms
Accounts Receivable Turnover: formula, what it measures and the benchmarks used to assess?
It measures: the average numbers of days it takes for a business to receive cash from its Accounts Receivable.
Benchmarks:
- Past Performance (trend analysis)
- Budgeted Performance
- Industry Average
- Credit Terms
Managing/Strategies to improve Accounts Payable Turnover
The ability to purchase inventory on credit is an important contributor to the liquidity of the business.
Strategies for managing Accounts Payable:
- Develop a strong relationship with each supplier
- Pay within, but as close as possible to, the credit terms.
- Pay early to earn discount revenue (if available and cash flow allows it).
- Check each Statement of Account against the Accounts Payable Ledger account – Verifiability / Faithful representation
- Appoint an Accounts Payable Officer / Clerk
Managing/Strategies to improve ARTO
- Offer discounts for quick settlement
- Send invoices promptly
- Conduct extensive credit checks
- Send reminder notices
- Threaten legal action
- Employ a debt collection agency
- Deny access to credit facilities
- Develop strong relationships with each customer
- Appoint an Accounts Receivable Officer / Clerk
Profit
Revenues earned minus expenses incurred, expressed in dollar terms.
Profitability
The ability of a business to generate a profit compared against a base of sales, assets or owner’s equity.
Non financial indicators that can be used to evaluate the profitability of a business.
- Number of repeat sales – repeat sales indicate satisfied customers plus do not require the $ investment in adverting and other forms of marketing.
- Number of sales returns – indicate that there are potentially dissatisfied customers, or alternatively staff are selling some customers the wrong product.
- Number of customer complaints – indication of dissatisfied customers who are unlikely to purchase your product again and can cause further brand damage through poor word of mouth.
- Number of hits to website – high traffic to the businesses website can indicate potential high sales, but would need to consider this with the conversation rate (i.e., percentage of visits that result in sales).
- Conversion rates (e.g. number of sales per brochure order, number of sales per visit to website) – the higher the conversion rate, the lower the costs per sale.
Cash Flow Cover
A liquidity indicator that measures the number of times Net Cash Flows from Operations is able to cover average current liabilities.
Working Capital Ratio
A liquidity indicator that measures the ratio of current assets to current liabilities, to assess the firm’s ability to meet its short-term debts as they fall due.
Strategies to improve Working Capital Ratio
If WCR is too low (less than 1:1):
- Improve cash flow from operations linked to profitability advice, turnovers/cash cycle (ARTO, ITO and APTO)
- Reduce drawings or make a capital contribution
- Renegotiate ST debts to become LT debts
If WCR is too high (e.g. 6:1):
- Reduce inventory levels
- reinvest excess cash in operations or alternate investments
- Owner withdraw cash.
Inventory Turnover
ITO assesses how effectively the firm has managed its inventory holdings, by calculating the average number of days taken to sell inventory.
Strategies to improve the Inventory Turnover
Increase sale of Inventory:
- Maintain an appropriate inventory mix – change from season to season as tastes and preferences change, so business must stay up to date.
- Promote the sale of complementary goods – this represents an add on sale that is generated from the original sale.
- Ensure inventory is up to date – must stop current version, moving older versions.•Rotate inventory – positioning of inventory in the store can impact sales.
- Determine an appropriate level of inventory on hand – too low, leads to loss of sales as customers go elsewhere, too high can result in inventory loss or write-down.
- Market strategically and effectively / ethically – in the right way to the right customers should ensure sales.
- Appoint an inventory manager – has responsibility for record keeping including checking the documents to ensure goods ordered and charged for are delivered, conducting inventory counts and ensuring relevant inventory handling procedures are followed and effective.
Decrease the level of Inventory on hand:
- Ordering less or smaller amounts more frequently (just-in-time approach)
Cash Cycle
Accounts Payable Turnover > Inventory Turnover + Accounts Receivable Turnover
This means that the business is selling it’s inventory and generation cash via cash sales or receipts from accounts receviable before it is used to pay its suppliers (i.e., Accounts Payable) - this is positive for liquidity, however, you would be forgoing any discount offered by your supplier.
Exert from Study Design relating to Financial Indicators
