Page 142 - DMGT310_ENTREPRENEURSHIP_AND_SMALL_BUSINESS_MANAGEMENT

Unit 9: Financial Considerations

Generally, it is calculated as: Notes
Sales
Inventory
It is also possible to be calculated as:

Cost of Goods Sold
Average Inventory
The first method of calculation is more frequently used, compared to cost of goods sold and
average inventory. The second method is used as sales are recorded at market value, while
inventories are recorded at value of procurement or cost. Use of average inventory instead of
ending inventory allows reduction of seasonal factors that may distort the correct ratio. It
measures the number of times inventory has been turned over in a financial year. It also indicates
the inventory quality in terms of its obsolescence and efficiency of inventory management
practices adopted by the venture.
High inventory turnover ratio is generally considered a positive sign of the venture efficiency.
If the venture has deployed significant resources in inventory, it is all the more important to
keep a track of this ratio as it helps in formulating proper financial plans. If the venture is
turning the inventory slowly, it would impact the cash flow of the venture. As with other ratios,
it needs to be compared with industry ratios. Another interpretation is, while low turnover
indicates poor sales and maintenance of extra inventory, affecting the blockage of funds and
increasing inventory holding cost and unproductive investments, a high ratio could be indicative
of either strong sales or improper purchases.
Average days payable ratio measures the average days, the venture takes to pay its suppliers.

Days in the period × Average accounts payable
Average Days Payable =
Purchases on credit
The “Days in the Period” denotes the number of days in the measurement period, which normally
consists of 365 days (One Financial Year). “Average Accounts Payable” is arrived at by taking
into consideration the opening and closing balances of accounts payable for the measurement
period. If accounts payable period of the venture is longer than the collection period, it may be
indicative of improper payment procedures or maintenance of poor cash position. It may affect
the credit rating of the venture. Contrarily, if the accounts payable period of the venture is
shorter, it indicates the venture is unable to maximize the benefits of purchases on credit,
though it can meet suppliers’ payment terms.

Leverage Ratios

These ratios measure financial leverage of the venture to meet financial obligations it has
created. Additionally, these indicate the capital structure of the venture and resultant strength
and weaknesses. The most significant ones focus on debt, equity, assets and interest features of
the venture. These also inform venture’s mix of operating costs (fixed and the variable), and how
changes in output will be affecting operating income. Ventures with relatively higher fixed
costs, having achieved the breakeven point (BEP) post higher amount of operating revenue
when output is increased compared to the ventures that have higher variable cost. It is brought
about by the fact that costs have already been incurred and after achieving the break even point
any increase in sales transfers to the operating income. Contrarily, in the ventures with high
variable costs, additional sales do not impart any such benefit because of higher incidence of

LOVELY PROFESSIONAL UNIVERSITY 137