Getting Behind the Numbers Timing Is Everything

RMA Journal, The, March, 2001 by Frank DiLorenzo

This is the third of several articles intended to identify situations in which further questioning of computer-generated financial ratios may be warranted. In this article, the author focuses on consolidated financial statements.

When a company experiences larger-than-normal sales revenue or makes larger-than-normal inventory purchases just prior to a period-end-generated financial statement, its turnover ratios can appear to be much different from reality.

Take a look at the partial balance sheet and partial income statement below. Calculating ABC company's accounts receivable days on hand for 1999 and 2000, we find a significant increase--from 30 days to 64 days.

ABC Company
                       FYE       FYE
(amts. in $000's)    12/31/99  12/31/00
Sales                  $900     $1,000
Cost of Goods Sold     $600       $667
Gross Profit           $300       $333
Accounts Receivable     $75       $175
A/R Days on Hand     30 days   64 days

At first glance one might think, "Wow, accounts receivable turnover has really slowed!" The problem with this thinking, however, is that AIR turnover did not slow at all!

What actually happened in this case was that ABC Company sold $100,000 of widgets to Acme Corporation on December 28, 2000. If this sale had not taken place, ABC'S partial income statement and accounts receivable would have appeared as follows on December 31, 2000:

ABC Company
(amts. in $000's)    12/31/00
Sales                  $900
Cost of Goods Sold     $600
Gross Profit           $300
Accounts Receivable     $75

Notice that this is exactly the same performance the company experienced in 1999. A/R days on hand, therefore, at 12/31/00 would have reflected the same 30 days average turnover that ABC experienced in 1999 if the $100,000 sale to Acme had not occurred.

Unfortunately, because ABC had a good thing happen (a $100,000 sale), it makes the average A/R days on hand appear as if they are taking twice as long to turn in year 2000, when, in fact, receivables are turning at exactly the same rate as they always have. Larger-than-normal sales volume late in the year (or just prior to any period-end financial statement) can play havoc with the calculation of accounts receivable turnover ratios.

A similar situation can affect inventory and payables turnover calculations. An inventory purchase late in the period, particularly if it is larger than normal, can make the inventory-days-on-hand calculation appear to be larger when inventory may in fact be turning at its normal rate. Payable turnover can also appear worse if that inventory was purchased on credit.

The Solution

There is only one way to know for sure at what rate accounts receivable, accounts payable, and inventory is turning--you need to get the agings schedules. From the agings schedules one can easily calculate the weighted average days on hand. For example:

amts. in $000s Accounts Receivable Aging Schedule
Days Past Invoice  0-30  31-60  61-90  91   Totals
 Totals            400    200    100   50    750
 Percent of Total  53%    27%    13%   7%   100%

If you multiply the percentage of total receivables that each category represents by the upper end of the number of days in each respective category (you can use 120 or 150 days for the upper end of the 91 category) and add the results together, you will then have a conservative estimate of the weighted average accounts receivable turnover. You could instead use the mid-range of each period (for example, 15 rather than 30 days in the first category) if you wanted to be less conservative.

Days Past Invoice    0-30  31-60  61-90  91   Totals
 Weighted Avg. Days   16    16     12    11   55 days

If the weighted average days on hand of receivables, payables, or inventory differs significantly from the spreadsheet-generated calculations, you'll need to dig deeper to find out why.

Looking only at the spreadsheet-generated turnover ratios can lead to erroneous conclusions. Days on hand can appear to be better or worse than reality. Taking the extra step--it takes only a few minutes--and comparing the results with the weighted average days on hand is the only way to really know

what is going on with a company's turnover ratios.

DiLorenzo is a senior vice president at Gulf Coast National Bank, which is part of First Bancorp., Inc., a $500 million bank holding company based in Naples, Florida.