How to Keep Inventory and Receivables Balanced
Originally published: 08.01.12 by Ruth King
Check these ratios monthly to detect problems with collections and materials.
For the past three months, I’ve written about the liquidity ratios (Can you pay your bills?); the debt ratios (Are you taking on too much debt?); and percentage compensation, (How productive are your employees?)
This month I’ll examine the last category of financial ratios — inventory days and receivable days. These ratios answer the questions, Do I have a collection problem, and am I building up too much inventory?
These ratios are calculated by using values from the balance sheet and the profit-and-loss statement. I also calculate inventory days differently from the “textbook” definition of inventory days. That version calculates the inventory days using material expense only. I include total cost of goods sold. In the HVAC industry, when companies sell a part, they sell the labor to install the part. Any time a company has material expense, it also has a labor expense. Thus, the ratio as I calculate it ensures profitable use of inventory by the field employees.
The inventory days and receivable days are calculated from the inventory turns and receivable turns. The days trends are what you need to watch each month.
The receivable-days ratio must be looked at in
Table 1 shows the inventory and receivable ratios that I track each month for a contractor. It is hard to decipher what is happening in this company just looking at the numbers.
Graph 1 shows the graph of the inventory and receivable ratios. Both the receivable days and inventory days increase and decrease each month. It’s hard to see what is happening because there are months where the accounts receivable days are as high as 100, and other months as low as 30. The inventory days also range.
The trailing data graph for this contractor shows a good story for inventory usage and a warning for receivable days. Inventory usage remains fairly constant on a long-term basis, which means that the company is being efficient with inventory. It is not building up inventory on a long-term basis.
However, the receivable days show a different story. The company has a collection problem. The fact that receivable days hit 100 days during a month is definitely a warning sign that someone had to start calling overdue accounts. The long-term trend is still rising. Even though the receivable-to-payables ratio is decreasing, (see my May 2012 HVACR Business column), the company’s receivable-days ratio is a warning sign to continue collection efforts. This ratio will eventually start decreasing on a long-term basis as the monthly receivable days start decreasing.
The last thing to look at is ensuring that the receivable days are higher than the inventory days, as they are with this contractor. This means that your company doesn’t have too much inventory. If both receivable days and inventory days are under 30 days, as they are with many residential contractors, there may be months where the receivable days are higher than inventory days and vice versa. Just ensure that they both stay under 30 days.
Take 15 to 30 minutes each month to calculate the 10 operating ratios I’ve written about over the past four months. Calculating the trends is critical to ensuring that your company can pay its bills, isn’t carrying too much debt, doesn’t have a collection problem, and is productive.
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and become more profitable. She is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. Ruth has written two books: The Ugly Truth About Small Business and The Ugly Truth About Managing People. Contact Ruth at email@example.com or 770.729.0258.
Articles by Ruth King
Understand Your P&L Statement: Gross Margin
Understand Your P&L Statement: Cost of Goods Sold
However you decide to categorize expenses in your P&L, it's important to be consistent.
Understand Your P&L Statement: Sales vs. Revenue
Sales are critical to survival — when revenue is actually generated is even more critical.
The 20 Percent Profit Myth
For a realistic goal, include owners’ compensation in the net profit equation.
Rethink Your Bonus Strategy
Enact a profit sharing program, rather than a bonus entitlement.