by An activity ratio is a type of financial metric that indicates how efficiently a company is leveraging the assets on its balance sheet, to generate revenues and cash. Commonly referred to as efficiency ratios, activity ratios help analysts gauge how a company handles inventory management, which is key to its operational fluidity and overall fiscal health.
Activity ratios are financial metrics used to gauge how efficient a company’s operations are. The term can include several ratios that can apply to how efficiently a company is employing its capital or assets.
Fixed Assets
Fixed assets are non-current assets and are tangible long-term assets that are non-operating, i.e., not used in the day-to-day activities of a company. Fixed assets usually refer to tangible assets that are expected to provide an economic benefit in the future, such as, property, plant, and equipment (PPE), furniture, machinery, vehicles, buildings, and land.
Fixed Assets Turnover measures how efficiently a company is using its fixed assets.
Fixed Asset Turnover = Revenue / Average Net Fixed Assets
A high ratio indicates that a company may need to invest more in capital expenditures (capex), and a low ratio may indicate that too much capital is tied up in fixed assets.
Working Capital
Working capital, also referred to as operating capital, is the excess of current assets over current liabilities. The level of working capital provides an insight into a company’s ability to meet current liabilities as they come due. Achieving a positive working capital is essential; however working capital should not be too large in order to not tie up capital that can be used elsewhere.
There are three main components of working capital are:
- Receivables
- Inventory
- Payables
The three accounts are useful in determining the cash conversion cycle, an important metric that measures the time in days in which a company can convert its inventory into cash.
Receivables
The accounts receivable turnover measures how efficiently a company is able to manage its credit sales and convert its account receivables into cash.
Receivables Turnover = Revenue / Average Receivables
A high receivables turnover signals that a company is able to convert its receivables into cash very quickly, whereas a low receivables turnover signals that a company is not able to convert its receivables as fast as it should.
The Days of Sales Outstanding (DSO) measures the number of days it takes to convert credit sales into cash.
Days of Sales Outstanding = Number of Days in Period / Receivables Turnover
Inventory
Inventory turnover measures how efficiently a company is able to manage its inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventory
A low inventory turnover ratio is a sign that inventory is moving too slowly and is tying up capital. On the other hand, a company with a high inventory turnover ratio can be moving inventory in a rapid pace; however, if the inventory turnover is too high, it can lead to shortages and lost sales.
Days of Inventory on Hand (DOH) measures the number of days it takes to sell inventory balance.
Days of Inventory on Hand = Number of Days in Period / Inventory Turnover
Payables
Payables turnover measures how quickly a company is paying off its accounts payable to creditors.
Payables Turnover = Cost of Goods Sold / Average Payables
A low payables turnover can indicate either lenient credit terms or an inability for a company to pay its creditors. A high payables turnover can indicate that a company is paying creditors too fast or it is able to take advantage of early payment discounts.
Days of Payables Outstanding (DPO) measures the number of days it takes to pay off creditors.
Days of Payables Outstanding = Number of Days in Period / Payables Turnover
Cash Conversion Cycle
As noted earlier, the cash conversion cycle is an important metric in determining how efficiently a company can convert its inventories into cash. Companies want to minimize their cash conversion cycle so that they receive cash from sales of inventory as quickly as possible. The metric indicates the overall efficiency of a company’s working capital/operating assets’ utilization.
Cash Conversion Cycle = DSO + DIH – DPO
Total Assets
Total assets refer to all the assets that are reported on a company’s balance sheet, both operating and non-operating (current and long-term). Total asset turnover is a measure of how efficiently a company is using its total assets.
Total Assets Turnover = Revenue / Average Total Assets
Types of Activity Ratios
- Total Assets Turnover Ratio
- Fixed Assets Turnover Ratio
- Current Assets Turnover Ratio
- Working Capital Turnover Ratio
- Stock Turnover ratio
- Debtor Turnover ratio
- Creditors Turnover ratio
- Total Assets Turnover Ratio
This ratio measures the efficiency of the firm in utilizing its Assets. A high ratio represents efficient utilization of total Assets in generating sales.
Total Assets Turnover Ratio = (Sales or Cost of Goods Sold)/ Total Assets
- Fixed Assets Turnover Ratio
This ratio measures the efficiency of the firm in utilizing its Fixed Assets. A high ratio represents efficient utilization of Fixed Assets in generating sales.
Fixed Assets Turnover Ratio = (Sales or Cost of Goods Sold)/ Fixed Assets
- Current Assets Turnover Ratio
This ratio measures the efficiency of the firm in utilizing its Current Assets. A high ratio represents efficient utilization of Current Assets in generating sales.
Current Assets Turnover Ratio: (Sales or Cost of Goods Sold)/ Current Assets
- Working Capital Turnover Ratio
This ratio measures the efficiency of the firm in utilizing its Working Capital. A high ratio represents efficient utilization of working Capital in generating sales.
Working Capital Turnover Ratio: (Sales or Cost of Goods Sold)/ Working Capital
Stock Turnover ratio
This ratio describes the relationship between the cost of goods sold and inventory held in the business. This ratio indicates how fast inventory/ Stock is consumed/ sold. A high ratio is good for the company. Low ratio indicated that stock is not consumed/ sold or remains in a warehouse for a longer period of time.
Stock Turnover ratio = Cost of Goods Sold/Average Inventory
Average Inventory = (Opening Stock + Closing Stock)/2
Debtor Turnover ratio
This ratio helps the company to know the collection and credit policies of the firm. It measures how efficiently the management is managing its accounts receivable. A high ratio represents better credit policy as compared to a low ratio.
Debtor Turnover ratio = Credit Sales/Average Debtors
Average Debtor = (Opening Debtor + Closing Debtor)/2
Creditors Turnover ratio
This ratio helps the company to know the payment policy that is being offered by the vendors to the company. It also reflects how management is managing its account payable. A high ratio represents that in the ability of management to finance its credit purchase and vice versa.
Creditors Turnover ratio: Credit Purchase/ Average Creditors
Average Creditor = (Opening Creditor + Closing Creditor)/2
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