PAYABLES & INVENTORIES ACTIVITY
There may be occasions when a firm wants to study promptness of its own payment to suppliers or that of a potential credit customer. In such cases, it may be desirable to obtain an aging of accounts payable, much like that just illustrated for accounts receivable. This method of analysis, combined with the less exact payable turnover (PT) ratio (annual credit purchases divided by accounts payable), allows us to analyze payables in much the same manner as we analyze receivables. Also, we can compute the payable turnover in days (PTD) or average payable period as
= Days in the Year / Payable Turnover
Accounts Payable x Days in the Year / Annual credit Purchase
Where accounts payable is the balance outstanding for the year and annual credit purchases are the external purchases during the year. This figure yields the average age of a firmâ€™s accounts payable.
When information on purchases is not available, one can occasionally use instead the â€œcost of goods sold plus (minus) any increase (decrease) in inventoryâ€? in determining these ratios. A department store chain, for example, typically does no manufacturing. As a result, the â€œcost of goods sold plus the change in inventoryâ€? consists primarily of purchases. However in situations where sizable value is added, as with manufacturer, the â€œcost of goods sold plus the change in inventoryâ€? is an inappropriate proxy for purchases. One must have the actual dollar amount of purchases if the ratio is to be used.
In the case of receivables, the use of a year end payable balance will result in a biased and high estimate of the time it will take a company to make payment on its payables if there is strong underlying growth. In this situation, it may be better to use an average of payables if there is strong underlying growth. In this situation, it may be better to use an average of payables at the beginning and end of the year.
The average payable period is valuable information in evaluating the probability that a credit applicant will pay on time. If the average age of payables is 48 days and the terms in the industry are â€œnet 30â€?, we know that a portion of the applicantâ€™s payables is not being paid on time. A credit check of the applicantâ€™s other suppliers will give insight into the severity of the problem.
Inventory Activity: To help determine how effectively the firm is managing inventory (and also to gain an indication of the liquidity of inventory), we compute the inventory turnover (IT) ratio
Cost of Goods sold/Inventory
Typically for a retail firm we have
(Beginning inventory) + (Purchases)-(Cost of goods sold) = Ending inventory
(Cost of goods sold)+ [(Ending inventory)-(Beginning inventory)] = Purchases
The figure for cost of goods sold used in the numerator is for the period being studied-usually a year; the inventory figure used in the denominator, through a year-end figure in our example, might represent an average value. For a situation involving simple growth, an average of beginning and ending inventories for the period might be used. As is true with receivables, however, it may be necessary to compute a more sophisticated average when there is a strong seasonal element. The inventory turnover ratio tells us how many times inventory is turned over into receivables through sales during the year. This ratio, like other ratios, must be judged in relation to past and expected future ratios of the firm and in relation to ratios of similar firms, the industry average, or both.
The higher the inventory turnover, the more efficient is the inventory management of the firm and the â€œfresherâ€?, more liquid, the inventory. Sometimes a high inventory turnover indicates a hand-to-mouth existence. It therefore might actually be symptom of maintaining too low a level of inventory and incurring frequent stock out. Relatively low inventory turnover is often a sign of excessive, slow-moving, or obsolete items in inventory. Obsolete items may require substantial write-downs, which, in turn, would tend to negate the treatment of some portion of the inventory as a liquid asset.
In conclusion we say as the inventory turnover ratio is a somewhat crude measure, we have to investigate further any perceived inefficiency in inventory management. In this regard, it is helpful to compute the turnover of the major categories of inventory to see if there are imbalances, which may indicate excessive investment in specific components of the inventory. We must investigate it more specifically to determine the cause once we have a hint of an inventory problem.