In our last Blog entry, we discussed Profitability Ratios, which can show you how well you are doing at making a profit. As a component of the DuPont pyramid, profitability ratios show you how well you are using your capital to generate sales (click here for an image of the pyramid).
The other component of Return on Capital consists of the activity ratios, which measure how well your company is using capital to support operations. It is often said, “It takes money to make money” and the activity ratios illustrate how well your company is using that money to operate. We should mention, first off, that although we use dollars to calculate ratios, often those dollars refer to non-monetary assets, such as equipment, plants and inventory. The dollar amounts may also denote credit and debt, which we will explain a bit later.
The top activity ratio in the DuPont pyramid is total asset turnover ratio. This ratio tells us how many times a business turns a dollar over during the time period studied. Another way to describe this ratio is to say how many times a dollar’s worth of assets creates a dollar’s worth of sales. The ratio is calculated as follows:
Average Total Assets
Average total assets is determined by dividing the sum of total assets at the beginning of the time period studied with total assets at the end of the period, divided by two. If a company had total average assets of $100,000 and had sales of $200,000, the Total Asset Turnover Ratio would be 2. In other words, each dollar of assets was “turned” 2 times during the time period. The more times that a dollar of assets is turned, the more efficiently you are using your capital.
Fixed Asset Turnover is especially important to those that have large investments in fixed assets such as plants, machines, trucks and other equipment. The Fixed Asset turnover ratio will tell you how well your company is using these assets. It is calculated:
Average Fixed Assets
If your company has $50,000 in fixed assets and $200,000 in sales, your Fixed Asset ratio would be 4. In other words each dollar of these assets was turned 4 times. The importance of this ratio is not only in how well you use your assets internally, but also in comparison to your competition. If your ratio is 4, and your competition is at 8, then you are much less efficient, and will find it hard to compete. If your competition is that much more efficient, they could lower prices to be more competitive.
The final activity ratio that we will look at is Working Capital Turnover. As you may recall, working capital represents the assets and cash that you need to keep your company operating. In previous Blog entries, I have often explained that a fast-growing company that is not well financed may run of cash and go out of business, despite success at selling a product or service. This ratio is also referred to as the cash cycle, in other words, how long does it take for a dollar to be create a product or service, and then be received back as payment.
Monitoring Working Capital Turnover will help you avoid that pitfall. There are three components to this ratio:
- Inventory Days: the number of days it would take to sell the inventory that you have on hand at your current sales rate.
- Receivable Days: the number of days, on average, that it takes you to collect a dollar of receivables. In essence, this ratio lets you know how much “interest free” credit you extend to your clients.
- Payable Days: The number of days, on average, that you take to pay a dollar of payables, the interest free credit that your vendors extend you.
The ratio is calculated:
Inventory Days X Receivable Days X Payable Days
If for example, your Working Capital ratio was 45, meaning that it takes 45 days to use a dollar to create a product or service (including paying for suppliers) and collect that dollar back in receivables. Many manufacturers and distributors keep too much capital tied up in inventory. Small manufacturers’ that find themselves in a cash crunch need to look at inventory, including Work In Progress, to be sure that they do not have too much on hand.
All businesses need to pay attention to receivables and payables, which are nothing more than credit that businesses extend to each other. Many a small business has gotten in trouble by purchasing goods and services at Net 60 and selling at Net 90. You must keep payables and receivable in balance in order not to have large amounts of cash tied up in this type of “loan” to your customers.
Now that we have covered the basics of a DuPont Analysis, the next Blog posting will be a practical application of a DuPont Analysis.