CHAPTER 12: OPERATING RATIOS – EFFICIENCY OF THE BUSINESS

CHAPTER 12: OPERATING RATIOS – EFFICIENCY OF THE BUSINESS

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Days Sales Outstanding
Days Payables Outstanding
Days of Inventories
Cash Conversion Cycle
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Table 1: Selected Financial Data Extracted from 2015 & 2016 Annual Reports
(in RM million)	Apex		Pharmaniaga
	2015	2016	2015	2016
Income Statement
Revenue/Sales	526.9	581.3	2,189.3	2,189.0
Cost of sales	407.1	452.9	1,836.5	1,845.8
Net Profit	34.2	35.0	84.0	45.6
Balance Sheet
Opening inventories*	51.7	60.9	427.0	539.9
Closing Inventories	60.9	65.8	539.9	532.2
Trade Receivables	123.1**	132.9**	147.7	161.3
Total Assets	390.2	418.4	1,495.6	1,683.1
Trade Payables	74.4***	80.1***	435.9	378.1
Short term borrowings	–	–	399.6	616.7
Long term borrowings	–	–	0.6	0.3
Shareholders’ fund	288.7	312.4	560.0	559.4
*Opening inventories are the closing inventories in the previous financial year. **Page 121 of Apex’s 2016 annual report, under notes to the accounts 20. Trade and Other Receivables  ***Page 127 of Apex’s 2016 annual report, under notes to the accounts 25. Trade and Other Payables.

 

Days Sales Outstanding
 
This ratio measures how many days it takes to collect payment from credit sales debtors.

Days Sales Outstanding =	Average Trade Receivables	X 365 days
	Sales

Using the numbers in the earlier Table 1:

Table 3: Days Sales Outstanding Calculation
Formula	=	Average Trade Receivables	X 365 days
		Sales
Apex	=	(RM123.1 m + RM132.9 m) / 2	X 365 days
		RM581.3 m
	=	80 days
Pharmaniaga	=	(RM147.6 m + RM161.3 m) / 2	X 365 days
		RM2,189.0 m
	=	26 days

From the ratio, the indication is that Pharmaniaga’s debt collection is faster than Apex. One possible reason is the client base. Pharmaniaga’s clients are mainly public hospitals, which have a more efficient payment policy, compared with Apex’s clientele which are mainly private clinics that have a longer collection period compared to public hospitals.

 Days Payables Outstanding
 
This ratio measures how many days the company takes to pay its trade creditors. In other words, it is how many days the company holds cash instead of paying suppliers.

As explained in the cash flow chapter in page 119, amount due to trade payables are actually a form of trade financing from the suppliers, and thus it is as good as receiving more “cash” to run the business. Therefore, the longer the company takes to pays its suppliers, the better the cash position of the company.

Days Payables Outstanding =	Average Trade Payables	X 365 days
	Purchases

In most cases, the income statement will feature Cost of Goods Sold/Cost of Sales instead of Purchases. Below is the relationship between Cost of Goods Sold/Cost of Sales and Purchases.

Cost of Goods Sold

=

Opening Inventories + Purchases – Closing Inventories

The logic is simple. Assume our business is selling calculators. At the beginning of the year we have 100 units of calculators at the cost of RM10 each. In the financial year, we bought additional 350 units of calculators at the same cost. At the closing of the year, we conduct an inventory check and find that we still have a balance of 80 units. So how many units of calculators were sold in the year and what’s the cost?

Units sold	= Opening inventories + Purchases – Closing inventories
	= 100 + 350 – 80
	= 370 units

With each unit costing RM10, the Cost of Goods Sold (goods being calculators in this case), is RM3,700 (RM10 x 370 units).

With this relationship, we can easily adjust the formula to derive Purchases:

Cost of Goods Sold	=	Opening Inventories + Purchases – Closing Inventories
Purchases	=	Cost of Goods Sold – Opening Inventories + Closing Inventories

Table 4: Calculation of Purchases
Formula	=	Cost of Sales – Opening Inventories
		+ Closing Inventories
Apex	=	RM452.9 m – RM60.9 m + RM65.8 m
	=	RM457.8 million
		RM1,845.8 m – RM539.9 m + RM532.2 m
Pharmaniaga	=
	=	RM1,838.1 million

Now that we have Purchases, the calculation for Days Payables Outstanding is shown in Table 5.

Table 5: Days Payables Outstanding Calculation
Formula	=	Average Trade Payables	X 365 days
		Purchases
Apex	=	(RM74.4 m + RM80.1 m) / 2	X 365 days
		RM457.8 m
	=	62 days
Pharmaniaga	=	(RM435.9 m + RM378.1 m)) / 2	X 365 days
		RM1,838.1 m
	=	81 days

The above means that on average, Apex pays its creditors within 62 days whilst Pharmaniaga holds cash for 81 days before the company pays the creditors. Similarly, if credit purchases information is available, it would be more reflective of the actual situation.

 Days of Inventories
 
This ratio measures how many days it takes for inventories to be sold. It shows how efficient management is in managing inventories. If inventories are not managed properly, i.e. buying or stocking up too much or even stocking up inventories that have no demand, the inventories will be held for a longer period than peers before they can be sold.

Days of Inventories =	Average Inventories	X 365 days
	Cost of Sales

Again, taking the financial numbers from Table 1 in page 140:

Table 6: Days of Inventories Calculation
Formula	=	Average Inventories	X 365 days
		Cost of Sales
Apex	=	(RM60.0 m + RM65.8 m) / 2	X 365 days
		RM452.9 m
	=	51 days
Pharmaniaga	=	(RM532.2 m + RM539.9 m) / 2	X 365 days
		RM1,845.8 m
	=	106 days

Apex on average holds its inventories for 51 days before selling it, while Pharmaniaga holds the inventories for 106 days before the inventories are sold.

 Cash Conversion Cycle

This ratio is a combination of the three ratios we explained earlier, being:

Cash Conversion Cycle

=

Days Sales Outstanding + Days Inventories Outstanding – Days Payables Outstanding

For a business, the cash movement starts with buying inventories from suppliers, converting the inventories to products and selling it to customers, collecting payment from customers, and then paying suppliers. This is what cash conversion cycles tell us. Thus, the shorter the cash cycle the better for the company.

Using the examples of Apex and Pharmaniaga:

Table 7: Cash Conversion Cycle
Formula	=	Days Sales Outstanding + Days Inventories
		Outstanding – Days Payables Outstanding
Apex	=	80 days + 51 days – 62 days
	=	69 days
		26 days + 106 days – 81 days
Pharmaniaga	=
	=	51 days

On an overall basis, Pharmaniaga shows a better cash cycle than Apex. The area that shows Apex losing the edge to Pharmaniaga is in terms of collection from debtors and credit terms received from creditors.

This concludes Chapter 12. Next week, we will explore Financing Ratios.

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