Question

Question 1

(a) How is Inventory Turnover Ratio calculated ? What might a sharp drop in inventory turnover tell us ?

(b) How do we calculate Days Sales Outstanding (DSO) ? What might a sharp increase in DSO tell us ?

(c) How do we calculate Operating Profit Margin? How might it be a better measurement of profitability than Net Profit Margin ?

(d) How do we calculate Current Ratio? What does it tell us?

Answer 1

(a) Inventory turnover ratio is calculated as per below:

Inventory turnover ratio = Cost of the goods sold / Average inventory

where, Average inventory = Beginning inventory + Ending inventory / 2

This ratio measures of how quickly inventory is sold. The higher this ratio, the better the performance. So, a drop in inventory turnover ratio will indicate that inventories are taking more time to sale.

(b) For day's sales uncollected, we need to calculate the accounts receivable turnover ratio first.

Accounts receivable turnover ratio = Sales / Average accounts receivables

where, Average accounts receivables = Beginning accounts receivables + Ending receivables / 2

Now, days' sales uncollected can be calculated as per below:

Days' sales uncollected = 365 / Accounts receivable turnover ratio

If there is a sharp increase in days' sales uncollected, then it would mean that it will take longer time for the business or company to collect its outstanding receivables.

(c) Operating profit margin can be calculated by the following formula:

Operating profit margin = Operating Profit / Net sales

Operating profit margin is a better measure of profitability than net profit margin because, operating profit margin shows the margin on operating or principal revenue generating activities. It excludes the margin from other income, which is temporary only and is shown by net profit margin ratio. It is a better measure as it gives the clearer picture of margins from operations of the company.

(d) Current ratio = Current assets / Current liabilities

Current assets are the assets that will be converted into cash or are realized within one accounting year. Current liabilities are liabilities that will be paid within one accounting period.

Current ratio tells about the liquidity position of the company. It shows whether the firm or the company will be able to meet its short term obligations. A current ratio of 2:1 is considered as good.