Ratio Analysis – Part IV: Turnover & Market Ratios

Financial statement analysis provides a window into a company’s operational efficiency and market standing. These ratios move beyond internal accounts, offering insights that matter to investors, creditors, and management alike. Let's examine how these tools work, why they matter, and how to interpret them confidently in both academia and the real world.

Introduction

Ratio analysis transforms raw numbers from a company’s financial statements into meaningful indicators of performance and health. Among the array of ratios, turnover and market ratios are especially telling. Turnover ratios measure how efficiently a business uses its assets, while market ratios help investors judge value and prospects. Understanding both categories equips you not only for exam success but also for practical business analysis.

Turnover/Activity Ratios

a. Inventory Turnover Ratio

Inventory Turnover Ratio shows how many times a company sells and replaces its inventory during a period. It highlights inventory management efficiency and is calculated as:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

A high ratio means quick inventory movement, reducing holding costs, while a low ratio may signal overstocking or slow-moving goods.

b. Debtors (Receivables) Turnover Ratio

Debtors Turnover Ratio measures how quickly a business collects cash from its customers. It’s computed as:

Debtors Turnover Ratio = Net Credit Sales / Average Accounts Receivable

The higher the ratio, the faster the collection cycle which is a sign of effective credit management. A low ratio may indicate collection problems or loose credit policies.

c. Creditors (Payables) Turnover Ratio

Creditors Turnover Ratio reflects how rapidly a company pays its suppliers. It is calculated as:

Creditors Turnover Ratio = Net Credit Purchases / Average Accounts Payable

A low ratio can suggest delayed payments, which might strain supplier relationships, while a very high ratio could mean the firm pays quickly, perhaps not taking full advantage of credit terms.

d. Working Capital Turnover Ratio

Working Capital Turnover Ratio gauges how effectively a firm uses its working capital to generate sales. The formula is:

Working Capital Turnover Ratio = Net Sales / Average Working Capital

A higher ratio suggests efficient use of working capital and a lower ratio may point to underutilization or excess investment in current assets.

Market Ratios

a. Price-Earnings (P/E) Ratio

P/E Ratio compares a company's current market price per share to its earnings per share (EPS):

P/E Ratio = Market Price per Share / Earnings per Share

This ratio is a favorite among investors, signaling how much they are willing to pay for each rupee of earnings. A high P/E may reflect growth expectations, while a low P/E could indicate undervaluation or company risk.

b. Dividend Yield Ratio

Dividend Yield shows the return on investment from dividends alone, not accounting for stock price appreciation. Calculated as:

Dividend Yield = Dividend per Share / Market Price per Share × 100

This ratio is crucial for income-focused investors evaluating the attractiveness of a stock’s cash returns.

c. Market-to-Book Value Ratio

Market-to-Book Value Ratio compares a company’s current market price to its book value per share:

Market-to-Book Value Ratio = Market Price per Share / Book Value per Share

It helps investors assess whether a stock is over- or undervalued relative to its accounting value. Ratios above 1 often indicate that the market perceives strong future prospects or intangible assets not captured on the balance sheet.

Illustration

Here's an example that illustrates the process:

Required: Calculate Debtors Turnover Ratio and Average Collection Period.

1. Find Average Debtors: (1,00,000 + 1,20,000) / 2 = 1,10,000
2. Debtors Turnover Ratio: 8,00,000 / 1,10,000 = 7.27 times
3. Average Collection Period: 365 days / 7.27 ≈ 50 days

This means, on average, the company collects its receivables in about 50 days.

How Investors Apply the P/E Ratio

Investors rely on the P/E ratio to compare a company’s valuation against industry peers and historical averages. A stock trading at a significantly higher P/E than its competitors may reflect expectations of superior growth or perceived safety. However, sometimes a high P/E is a warning sign of overvaluation. Conversely, a low P/E can be attractive, but it’s essential to ask:
Is the market expecting poor future performance?

For example, if Company A has a P/E of 25 and Company B in the same sector has a P/E of 15, an investor might question whether Company A’s growth prospects justify the premium. This critical thinking is at the heart of real investment decisions.

Notes

• If a company’s inventory turnover ratio increases steadily, it generally means improved inventory management, goods are selling faster.
• A declining debtors turnover ratio signals potential collection issues or relaxed credit standards.
• A P/E ratio much higher than the industry average may suggest overvaluation or investor optimism about future earnings. Conversely, a very low P/E could mean undervaluation or that the company faces significant risks.

Always link your interpretation to the company’s business context. Is it a seasonal business? Is the industry growing? These angles demonstrate both technical knowledge and real-world understanding.

Core Turnover & Market Ratios

Remember: Ratio analysis is both a science and an art. Calculations must be precise, but thoughtful interpretation sets you apart. Keep practicing problems, compare ratios across companies, and always challenge yourself with, “What story do these numbers tell?”