Question

1. Write the formula for the following ratios and what each ratio measures:

1. Collection Period (also called “account receivable period”)
2. Payables Period (also called “account payable period”)
3. Operating Cycle
4. Cash Conversion Cycle
5. Financial Leverage (also called “equity multiplier” )
6. Debt-to-assets ratio
7. Debt-to-equity ratio
8. Times interest earned

Answer 1

Collection Period (also called “account receivable period”)

The average collection period formula is the number of days in a period divided by the receivables turnover ratio.

The numerator of the average collection period formula shown at the top of the page is 365 days. For many situations, an annual review of the average collection period is considered. However, if the receivables turnover is evaluated for a different time period, then the numerator should reflect this same time period.For example, if the receivables turnover for one year is 8, then the average collection period would be 45.63 days. If the period considered is instead for 180 days with a receivables turnover of 4.29, then the average collection period would be 41.96 days. By the nature of the formula, a company will have a lower receivables turnover when a shorter time period is considered due to having a larger portion of its revenues awaiting receipt in the short run.

Payables Period (also called “account payable period”)

To calculate accounts payable days, summarize all purchases from suppliers during the measurement period, and divide by the average amount of accounts payable during that period. The formula is:

Total supplier purchases ÷ ((Beginning accounts payable + Ending accounts payable) / 2)

This formula reveals the total accounts payable turnover. Then divide the resulting turnover figure into 365 days to arrive at the number of accounts payable days.

The formula can be modified to exclude cash payments to suppliers, since the numerator should include only purchases on credit from suppliers. Otherwise, the number of payable days will appear to be too low. However, the amount of up-front cash payments to suppliers is normally so small that this modification is not necessary.

Operating Cycle

The formula is very simple as all the required information is easily available in the balance sheet and the income statement and it can be derived by using the following three steps:

Step 1: Firstly, determine the average inventory during the year which can be calculated as the average of opening inventory and closing inventory from the balance sheet. Then, the COGS can be computed from the income statement. Now, the inventory period can be calculated by dividing the average inventory by COGS and multiplied by 365 days.

Inventory Period = Average Inventory / COGS * 365

Step 2: Next, determine the average accounts receivable during the year which can be calculated as the average of opening accounts receivable and closing accounts receivable from the balance sheet. Then, the net credit sales can be taken from the income statement. Now, the accounts receivable period can be calculated by dividing average accounts receivable by net credit sales and multiplied by 365 days.

Accounts Receivable Period = Average Accounts Receivable / Net credit sales * 365

Step 3: Finally, it can be calculated by adding the inventory period and accounts receivable period

Cash Conversion Cycle

Calculating the CCC may seem intimidating at first, but once you understand the elements involved in the calculation, it isn't as confusing.

You'll need to reference your financial statements such as the balance sheet and income statement to give you information for the calculations. The cash conversion cycle formula has three parts: Days Inventory Outstanding, Days Sales Outstanding, and Days Payable Outstanding.

Days Inventory Outstanding

The first part of the equation is Days Inventory Outstanding (DIO). This is the average time to convert inventory into finished goods and sell them.

DIO = (Average Inventory ÷ Cost of Goods Sold) x 365

Your average inventory (in value) for the period is your beginning inventory value + ending inventory value ÷ 2.

(Beginning Inventory + Ending Inventory) ÷ 2

The cost of goods sold is:

Beginning Inventory + Purchases - Ending Inventory.

Days Sales Outstanding

Days Sales Outstanding (DSO) is the average amount of time in days that your accounts receivable (your business is owed money) are waiting to be collected.

DSO = (Accounts Receivable ÷ Net Credit Sales) x 365

Your accounts receivable for this element are the average of your beginning and ending receivables.

(Beginning Receivables + Ending Receivables) ÷ 2

Days Payable Outstanding

The Days Payable Outstanding (DPO) is the average length of time it takes a company to purchase from its suppliers on accounts payable—your business owes money—and pay for them.

DPO = Ending Accounts Payable ÷ (Cost of Goods Sold ÷ 365)

Accounts payable in this element is:

(Beginning Payable + Ending Payable) ÷ 2.

Calculating the Cash Conversion Cycle

Once you have calculated all three of the required elements of the formula, you can calculate the CCC.

Cash Conversion Cycle (CCC) = DIO + DSO - DPO

Financial Leverage (also called “equity multiplier” )

Financial leverage refers to the utilization of borrowed funds to acquire new assets which are assumed to generate a higher capital gain or income as compared to the cost of borrowing. It is a liability for the borrowing business organization whereas, makes a source of income for the lender.

EBIT / EPS

Debt-to-assets ratio

The formula for the debt to asset ratio is as follows:

Debt/Asset = (Short-term Debt + Long-term Debt) / Total Assets

Where:

• Total Assets may include all current and non-current assets on the company’s balance sheet, or may only include certain assets such as Property, Plant & Equipment (PP&E), at the analyst’s discretion.

Debt-to-equity ratio

Debt to Equity Ratio=Total Shareholders/EquityTotal Liabilities​​

Times interest earned

The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations based on its current income. The formula for a company's TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt.