Activity ratios

From CEOpedia | Management online

Activity ratios present how fast assets of the company can be converted to cash. It is especially important for manufacturing companies, which use many raw materials, inventory, etc. The activity ratios can help determine how well managers do they job in their optimization. Comparison between competitors shows which of the companies is more efficient.

Types of activity ratios

There are several activity ratios. Among them the most important are [1]:

  • Accounts receivable turnovern ratio - ability to collect money from customers
  • Accounts payable turnover ratio - it informs how many times the liabilities are repaid.
  • Fixed assets turnover ratio - examines the effectiveness of management in the company in terms of investments in fixed assets
  • Total assets turnover ratio - efficiency of using assets to make sales
  • Return on investment (ROI) ratio - informs about the efficiency of managing all of a firm's assets
  • Inventory turnover ratio - how often inventory balance is sold during an accounting period

Accounts receivable turnover ratio

Accounts receivable turnover ratio informs how many times in a given period the state of the company's receivables has been renewed [2].
The formula is:
Accounts receivable turnover = Net sales / Average accounts receivable

Acounuts payable turnover ratio

Accounts payable turnover rato informs how many times the level of liabilities is repaid on average over a given period [3].
The formula is:
Accounts payable turnover = Cost of sales / Average accounts payable

Fixed assets turnover ratio

Fixed assets turnover ratio examines the effectiveness of management in the company in terms of investments in fixed assets. Usually calculated in the annual pile. The formula is[4]:
Fixed Assets Turnover Rate: Net Sales / Fixed Assets

Total assets turnover ratio

Total assets turnover ratio - informs about sales effectiveness using all resources.
The formula is:
Assets Turnover Rate = Net Sales / Total Assets

Return on investment (ROI) ratio

Return on investment ratio is draws attention to capital management in the enterprise. It informs about the effectiveness of the company's operation to generate profits from capital invested by shareholders [5].
The formula is:
Return on investment (ROI)= Net profit after taxes/Total paid in capital

Inventory turnover ratio

Inventory turnover ratio measures how many times a stock has to be returned in a given period.The shorter the time from the purchase of the stock to its sales, it is a higher inventory turnover ratio. Conversely, if a company needs more time to sell stocks, the smaller the indicator will be [6].
The formula is:
Inventory Turnover ratio = Costs of Goods Sold / Average Inventory

Examples of Activity ratios

  • Accounts Receivable Turnover Ratio: This ratio measures how quickly customers are paying off their debts. It is calculated by dividing the net credit sales by the average accounts receivable. A higher ratio indicates that customers are paying off their debts faster, which is usually a sign of an efficient accounts receivable system. For example, if the net credit sales of a company are $1,000,000 and the average accounts receivable is $200,000, the accounts receivable turnover ratio would be 5.
  • Inventory Turnover Ratio: This ratio measures how quickly a company is selling its inventory. It is calculated by dividing the cost of goods sold by the average inventory. A higher ratio indicates that the company is selling its inventory more quickly, which is usually a sign of an efficient inventory management system. For example, if the cost of goods sold of a company is $800,000 and the average inventory is $100,000, the inventory turnover ratio would be 8.
  • Asset Turnover Ratio: This ratio measures how efficiently a company is using its assets to generate revenue. It is calculated by dividing the total revenue by the average total assets. A higher ratio indicates that the company is using its assets more efficiently, which is usually a sign of an efficient management system. For example, if the total revenue of a company is $2,000,000 and the average total assets is $500,000, the asset turnover ratio would be 4.

Advantages of Activity ratios

Activity ratios offer numerous advantages to companies. These advantages include:

  • Improved financial planning and forecasting: Activity ratios can be used to estimate the amount of cash that will be generated from assets in the future. This helps guide decisions on investments and other financial activities.
  • Increased efficiency and profitability: By analyzing activity ratios, companies can identify areas where they are inefficient in terms of asset management. This can lead to improved processes and cost savings that increase profit margins.
  • Better understanding of competitors: Activity ratios can be used to compare performance between competitors. This can help companies identify areas where their competitors are outperforming them and make adjustments accordingly.
  • Improved resource allocation: Activity ratios can help companies identify the most profitable use of their resources. This can lead to better allocation of resources and improved overall performance.

Limitations of Activity ratios

One of the main limitations of Activity ratios is that they do not necessarily reflect the underlying performance of the business.

  • Activity ratios do not provide an absolute measure of performance, as they are based on the past performance and may not accurately represent the current situation.
  • Another limitation is that they do not take into account the company's financial position, such as cash flow, debt levels, and other factors.
  • Activity ratios can be easily manipulated by management, as they involve subjective decisions in calculating the ratios.
  • They do not take into account the company's competitive environment and the changing market conditions, which can influence the performance of the business.
  • Activity ratios also do not provide any insight into the underlying quality of the assets or processes of the business.
  • Finally, Activity ratios are based on historical data, which may not accurately reflect the current situation, and thus, may not be reliable in predicting future performance.

Other approaches related to Activity ratios

Other approaches related to Activity ratios include:

  • Analyzing the Collection Period (Accounts Receivables Turnover) - this helps to identify how long it takes for customers to pay for their purchases. It is especially important for companies that offer credit to their customers.
  • Analyzing the Inventory Turnover - This approach helps to determine how quickly a company can turn their inventory into sales. It is important for companies that manufacture products, as it helps to determine how efficient their processes are.
  • Analyzing the Payables Turnover - This helps to determine how quickly a company can pay its bills. It is important for companies that are dependent on suppliers, as it helps them to make sure they are staying on top of their payments.

In summary, Activity ratios are key indicators of the effectiveness of a company’s operations and can be used to compare the efficiency of different companies. Other approaches related to Activity ratios include analyzing the Collection Period, Inventory Turnover, and Payables Turnover.


Activity ratios — recommended articles
Burn Rate — Du Pont analysis — Defensive interval ratio — Days payable — Accounting ratios — Operating expense ratio — Common-size financial statement — Payables turnover — Average collection period — Identity of the company

References

Footnotes

  1. ↑ Moghimi, R., Anvari, A., 2014, p. 571
  2. ↑ Tugas F. C., 2012, p. 175
  3. ↑ Tugas F. C., 2012, p. 174
  4. ↑ Kazan H., Ozdemir O., 2014, p. 211
  5. ↑ Kabajeh M. A. M., Al Nuaimat, S. M. A., Dahmash, F. N., 2012, p. 116
  6. ↑ Moghimi, R., Anvari A., 2014, p. 571

Author: Justyna Banowska

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