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What Is An Activity Ratio?: Key Takeaways

An activity ratio indicates how efficiently a company uses its assets to generate revenue and cash flow. Common activity ratios include inventory turnover, which measures how quickly inventory is sold, accounts receivable turnover, which shows how fast customers pay, and total asset turnover, which indicates overall efficiency in using all assets. These ratios help analysts evaluate asset use and compare efficiency across companies or over time at one company.

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299 views5 pages

What Is An Activity Ratio?: Key Takeaways

An activity ratio indicates how efficiently a company uses its assets to generate revenue and cash flow. Common activity ratios include inventory turnover, which measures how quickly inventory is sold, accounts receivable turnover, which shows how fast customers pay, and total asset turnover, which indicates overall efficiency in using all assets. These ratios help analysts evaluate asset use and compare efficiency across companies or over time at one company.

Uploaded by

Tao Tma
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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What Is an Activity Ratio?

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.

KEY TAKEAWAYS

 An activity ratio broadly describes any type of financial metric that helps investors
and research analysts gauge how efficiently a company uses its assets to
generate revenues and cash.
 Activity ratios may be utilized to compare two different businesses within the
same sector, or they may be used to monitor a single company's fiscal health
over time.
 Activity ratios can be subdivided into merchandise inventory turnover ratios, total
assets turnover ratios, return on equity measurements, and a spectrum of other
metrics.

Understanding Activity Ratios


Activity ratios are most useful when employed to compare two competing businesses
within the same industry to determine how a particular company stacks up amongst its
peers. But activity ratios may also be used to track a company's fiscal progress over
multiple recording periods, to detect changes over time. These numbers can be mapped
to present a forward-looking picture of a company's prospective performance.

Activity ratios can be broken down into the following sub-categories:

Accounts Receivable Turnover Ratio


The accounts receivable turnover ratio determines an entity's ability to collect money
from its customers. Total credit sales are divided by the average accounts receivable
balance for a specific period. A low ratio suggests a deficiency in the collection process.

Merchandise Inventory Turnover Ratio


The merchandise inventory turnover ratio measures how often the inventory balance is
sold during an accounting period. The cost of goods sold is divided by the average
inventory for a specific period. Higher calculations suggest that a company can move its
inventory with relative ease.

Total Assets Turnover Ratio


The total assets turnover ratio measures how efficiently an entity uses its assets to
tender a sale. Total sales are divided by total assets to decipher how proficiently a
business uses its assets. Smaller ratios may indicate that a company is struggling to
move its products.

Return on Equity
A performance metric knows as return on equity (ROE) measures the revenues raised
from shareholder equity. ROE is calculated by dividing net income by all outstanding
stock shares in the market.

Asset Turnover Ratio


A metric called the asset turnover ratio measures the amount of revenue a company
generates per dollar of assets. This figure, which is simply calculated by dividing a
company's sales by its total assets, reveals how efficiently a company is using its assets
to generate sales.

Activity Ratios Vs. Profitability Ratios


Activity ratios and profitability ratios are both fundamental analytical tools that help
investors evaluate different facets of a company's fiscal strength. Profitability ratios
depict a company's profit generation, while efficiency ratios measure how well a
company utilizes its resources to generate those profits. Profitability ratios may help
analysts compare a company's profits with those of its industry competitors, while also
tracking the same company's progress across several different reporting periods.

1. 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

2. 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.

 
3. 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

A high ratio indicates that a company is using its total assets very efficiently or that it
does not own many assets, to begin with. A low ratio indicates that too much capital is
tied up in assets and that assets are not being used efficiently in generating revenue.

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