Working capital management ratios – 4 in series of 6 on financial ratios
In this post, I’ll detail some ratios which can helps a business manage its working capital (working capital is current assets less current liabilities). A business can calculate a ratio for each of inventory, trade receivables, and trade payables which help interpret how well working capital is managed. In my previous post, I showed some ratios which help determine liquidity and solvency; with the ratios below, we have all elements of working capital covered (including cash) .
The first ratio is inventory turnover, which is calculated as follows:
Inventory turnover: Cost of sales
Average inventory
This ratio tells us how many times a year inventory is sold. You’ll notice the bottom line says “average inventory”, which might be a simple average of the inventory at the start of the year and the end of the year, or a rolling average. The reason for using an average is to try to remove seasonal variations.
The next ratio reflects how well trade receivables are managed:
Average period of credit given: Trade receivables x 365
Credit sales
This ratio tells how many days credit, on average, is given to customers. The top line is multiplied by 365 to give the answer in days. If you want it in months, multiply by 12 instead. If the period of credit given is getting longer, this could be problematic, as cash is not collected as fast by the business.
Now let’s see the average period of credit taken. This is very like the previous one, except it relates to suppliers. It is calculated as follows:
Average period of credit taken: Trade payables x 365
Credit purchases
One thing to note about this ratio is that it may not always be possible to obtain the credit purchases figure from published financial statements. The period of credit taken should not be too long either. If it is getting longer, it may be a sign of cash flow problems.
As in my previous posts, I’ll now calculate the above ratios using the figures from the 2010 annual report of Diageo plc.
The inventory turnover is: 4099 (3281+3078)/2 = (data from p.106/108) =1.2 times per annum. This means the company sells its inventory just over once per year. This probably seem really low if you think about how quickly beer and other alcohol sells in a retail sense. However, if we look at the detailed notes on inventory in the annual report, we can see that about 2/3 of the inventory is deemed “maturing” inventory.
The average period of credit given is: 1495 x365/9780 = 56 days (data from p.106/140). This seems a reasonable period of credit.
The average period of credit taken is: 843 X 365/4099 ) =75 days (data from p.106/148). Note that I am using the cost of sales figure as a substitute for the credit purchases figure – which is typically not available in published accounts. Again this figure seems reasonable and is longer than the period of credit given, which makes logical sense.
In summary from the figures above, the working capital of Diageo plc seems well managed.
Martin's accounting blog 
Good basic information although one has to be very careful of seasonal,cyclical and one off events like floods/earthquakes and political turmoil like riots that causes such calculations to become distorted. This is not to mention the issues associated with incorrect accounting/sector/industry and of course geographical complications.
Thanks John, you’re absolutely right. In the post, as you say, I am trying to cover the basics.
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