Financial Ratio: Operating Ratios (Part 3)

Account Receivable Turnover and Days Sales Outstanding Ratios explained.

Before this, we have spoken about the Profitability Ratio category, which is a part of the whole financial ratio analysis. We have also touched on some ratios under the Operating Ratios, particularly the Fixed Asset Turnover Ratio, Working Capital Turnover Ratio, Total Asset Turnover, Inventory Turnover, and Inventory Number of Days

Here’s a little bit of catching up — when considering investments or trades, there are generally two approaches used by people to analyze their prospects. These approaches are known as technical analysis and fundamental analysis.

Each approach utilizes different methods to evaluate the worthiness of companies for investment. In this case, we will focus on the fundamental investors, also known as value investors, and their way of evaluating investments.

In a nutshell, fundamental investors seek to identify the intrinsic value of a company. They do this by examining the financial statements of the company, including the Profit & Loss Statement, Balance Sheet, and Cash Flow Statement. For a comprehensive guide on how to read these statements, you can click on the hyperlinks provided.

How do they examine all the financial statements above? By using financial ratios! If you want a general overview of how financial ratios work, check out this article — Fundamental: Introduction to Financial Ratios.

Please also look at the chart below to get a full picture of where we are:

So, we are in the “Operating Ratio” category while the types of ratios that we are going to discuss for now are the Total Asset Turnover, Inventory Turnover and Inventory Number of Days.

Quick note

For capital-intensive companies, it may be more appropriate to use financial ratios that are specifically designed to evaluate their performance, such as the return on invested capital (ROIC) or the asset turnover ratio. The ROIC measures the return that a company generates on the capital it has invested in its operations, while the asset turnover ratio measures how efficiently a company is using its assets to generate revenue.

Now, for this article, we will take Apple as our example (despite Apple being capital-intensive) because we think Apple’s annual report is well-structured and easy to use for beginners, but IRL, the operating ratio is more suitable for companies that are not capital intensive such as banks, etc.

Account Receivable Turnover

The accounts receivable turnover ratio tells an investor how quickly a company is able to collect payments from its customers who have purchased goods or services on credit. A higher accounts receivable turnover ratio generally indicates that a company is collecting payments from its customers more quickly, which can be a good sign of financial health. This may suggest that the company has efficient credit policies, strong customer relationships, and effective collection procedures.

In simpler terms, the number will tell you how many times a company can collect its average account receivable balance in a particular [period (usually a year or a quarter).

How to calculate Account Receivable Turnover?

The formula is as follows:

Account Receivable Turnover = Revenue / Average Receivables

Where:

Average Receivables = [Account Receivable in Year 1 + Account Receivable in Year 2] / 2

How to find all those things?

We’ll have a look at Apple’s Annual Report which you can download here.

First, you can have a look at its Statements of Operations to get its total revenue, and mind you, revenue here refers to the money that they made from their operations, be it selling iPhones, iPads, Apple Music service, or whatever — and it refers to the money untainted by taxes, etc. It’s fresh from the customers’ wallets.

From here, you can see that Apple’s operating revenue is $394,328 million.

Then, head over to Apple’s Balance Sheets to look for Average Receivables. Here, you can calculate the Average Receivables from the numbers shown in its Account Receivables section below:

Question — why don’t we take the “Vendor non-trade receivables” values? That’s because the accounts receivable turnover ratio tells an investor how quickly a company is able to collect payments from its customers, not from vendors.

Let’s get moving!

Account Receivable Turnover = Revenue / Average Receivables

Revenue = 394,328

Average Receivables = (28,184 + 26,278) / 2 = 27,231

Account Receivable Turnover = 394,328 / 27,231

Account Receivable Turnover = 14.48

So, you can say that in FY22 (as of September), Apple successfully collected its average account receivable balance around 14 times.

Days Sales Outstanding (DSO)

The Days Sales Outstanding (DSO) ratio (a.k.a Average Collection Period / Day Sales in Receivables) tells investors the average number of days it takes for a company to collect payments from its customers after making a sale on credit. A lower DSO ratio generally indicates that a company is collecting payments from its customers more quickly, which can be a good sign of financial health. This may suggest that the company has efficient credit policies, strong customer relationships, and effective collection procedures.

How to calculate Days Sales Outstanding?

The formula is as follows:

Days Sales Outstanding = (days in the period) / Receivable Turnover Ratio

Days Sales Outstanding = 365 / Receivable Turnover Ratio

We already got the Receivable Turnover Ratio above, so let’s just do it quickly and get to the point.

Days Sales Outstanding = 365 / 14.48

Days Sales Outstanding = 25.21

So, you can say that in FY22 (as of September), it takes Apple around 25 days to collect payments from its customers after making a sale on credit.

Bottom line

Account Receivable Turnover tells you how many times in a certain period the company is able to collect their ‘debts’, while DSO Ratio tells you how long it takes for the company to collect them.
The higher the Account Receivable Turnover ratio, the more efficient the company is at collecting their money.
The lower the DSO, the more efficient the company is at collecting their money.
All these ratios should be analyzed in conjunction with other financial metrics and factors before making any investment or business decisions.

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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.

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