The Essence of Measuring and Managing Return on Equity by Sundar Venkatesh

Author:Sundar Venkatesh [Venkatesh, Sundar]
Language: eng
Format: mobi
Publisher: ConnectEd Learning and Development
Published: 2011-11-06T04:00:00+00:00

• Rolling over their Working Capital frequently, thus maximizing their Sales/ Working Capital ratio

Similar to analysis of Profitability, analysis of Asset Utilization must consider the industry, strategy and business models relevant to the company being analysed. It is only with such background that the different performance measures can be correctly interpreted.

Table 5. 2: Different measures of Asset Utilization

With Accounts Receivable, Inventory and Accounts Payable, the computation of the ratio is inverted. The resulting number is easier to communicate. Days receivable is the number of days, on an average, that a company has to wait before being paid by its customers. Larger the days receivable, longer the wait. Longer the wait, more the company has to depend for cash from other and more expensive sources such as banks, other lenders and shareholders. A similar interpretation can be made of Days Inventory. Days payable has an opposite effect. Longer a company can make its suppliers wait, better it is for the company’s ROE.

The computation of Days Inventory and Days Payable use COGS instead of Sales. The reason is that unlike Accounts Receivable which is computed using selling prices, Inventory and Accounts Payable are computed using cost to the company.

Among the factors affecting Sales/Fixed Assets, important are capacity utilization and market demand. Capacity is a term that is not easy to define in many businesses. A fruit juice maker may define capacity of crushing and juicing differently from packing. Not all fixed assets are used in manufacturing.

To maximise Sales/Fixed Assets, a company must not only use its capacity to produce and sell the largest volumes possible but also sell more of the higher priced products in the mix. This depends on demand in the market.

Performance on Sales/Working capital depends on performance on the elements that constitute working capital viz. Accounts Receivable, Inventory and Accounts Payable. Accounts Receivable is the result of a company’s credit policy to its customers and collection efficiency. In competitive situations, credit period can be used as tool to boost sales. The downside is the negative effect on cash flows and possible increase in bad debts. Similarly, holding larger volume and a wider variety of inventory can boost sales. On the negative side is risk of obsolete inventory, cost of space and insurance to keep the inventory and the interest cost of financing such inventory. Days payable should be increased but supplier power and maintaing long term relationships with supplier can be considerations in delaying payments for too long.

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