What is an Activity Ratio?
An activity ratio is a type of accounting ratio. It is a financial indicator that shows how effectively a company is generating revenue and cash by using its assets on its balance sheet. It demonstrates how effectively the company’s assets are being used by management to create the most revenue feasible. Analysts use activity ratios to compare two organisations in the same industry. They also use it to evaluate the financial health of a single company over time.
Types of Activity Ratios
- Total Assets Turnover Ratio
- Fixed Assets Turnover Ratio
- Working Capital Turnover Ratio
- Stock Turnover Ratio
- Debtors or Accounts Receivable Ratio
- Creditors or Accounts Payable Ratio
Total Assets Turnover Ratio
The asset turnover ratio evaluates a company’s efficiency in utilising its assets. A high ratio indicates that total assets are being used efficiently to generate sales. This indicator aids investors in determining how efficiently businesses use their assets to create revenue. The investors use asset turnover ratio to compare companies in the same sector or group.
Large asset sales as well as considerable asset purchases in a given year can have an impact on a company’s asset turnover ratio.
Sales or Cost of Goods Sold/ Average Total Assets
Where, Sales- Annual cost of goods sold or sales
Average Total Assets- (Total asset at the beginning of year + Total asset at the end of year) / 2
Fixed Assets Turnover Ratio
The fixed asset turnover ratio measures how well a company generates revenue from its existing fixed assets. A higher ratio indicates that management is making better use of its fixed assets. The fixed assets include property, plant, and equipment less accrued depreciation. FAT may be beneficial in evaluating and monitoring the return on money invested for investors looking for investment prospects in industries with capital-intensive businesses.
Sales or Cost of Goods Sold)/ Average Net Fixed Assets
Sales – Annual cost of goods sold or sales
Average Net Fixed Assets- (Net fixed asset at the beginning of year + Net fixed asset at the end of year) / 2
Net Fixed Assets – Gross Fixed Assets – Accumulated Depreciation
Working Capital Turnover Ratio
The working capital turnover ratio determines how well a company uses its working capital to support a particular level of sales. Working capital is the difference between current assets and current liabilities. A high turnover ratio suggests that management is maximising the use of a company’s short-term assets and liabilities to drive sales. A low ratio, on the other hand, shows that a company is investing too much in accounts receivable and inventory assets to sustain its sales. This might potentially lead to a large number of bad debts and obsolete inventory write-offs.
Sales or Cost of Goods Sold)/ Average Working Capital
Average Working Capital – Average current assets – average current liabilities
Stock Turnover Ratio
The stock turnover ratio describes how much of the company’s stock has been transformed into sales. Inventory turnover ratio is the number of times a company’s inventory is sold during a certain period. A high inventory turnover ratio indicates that a company has effective inventory controls as well as strong sales strategies. It explains how effective the company is at turning stock into sales. A low ratio suggests a lack of demand, an out-of-date product, or a poor sales/ inventory policy, among other things. Among other activity ratios, stock, account payable and account receivable turnover ratios are very popular.
Sales or Cost of Goods Sold)/ Average Stock
Average Stock – (Inventory at the beginning of the year + Inventory at the end of the year) / 2
Debtors or Accounts Receivable Ratio
The accounts receivable turnover ratios are a metric in accounting to determine how efficiently a company collects receivables from its customers.
The ratio also calculates the number of times receivables are converted to cash over a given period of time. A high ratio could imply that a company’s collection practices are effective with credible customers who pay their debts on time. Inefficient collection operations, weak credit policies, or consumers who are not financially viable or creditworthy could all contribute to a low percentage. Investors should be aware that certain companies compute their ratios using total sales rather than net sales, which might inflate the figures.
Net Credit Sales / Average Accounts Receivable
Average Accounts Receivable – (Accounts receivable at the beginning of the year + Accounts receivable at the end of the year) / 2
Creditors or Accounts Payable Ratio
The average number of times a company pays its creditors throughout is measured by the accounts payable turnover ratio. A higher payable turnover ratio is more beneficial, as it is an indicator of short-term liquidity. The easiest way to evaluate a company’s turnover ratio, as with most financial measures, is to compare it to similar companies in its industry.
Net Credit Purchases / Average Accounts Payable
Average Accounts Payable – (Accounts payable at the beginning of the year + Accounts payable at the end of the year) / 2
Importance of Activity Ratios
Activity ratios are especially effective when comparing two competitive businesses within the same industry. It helps to understand the effectiveness of one company in comparison to its competitors. Activity ratios, on the other hand, can be used to analyze a company’s financial development throughout many accounting periods and uncover changes over time. These figures can be mapped to create a growth potential of a company’s performance.
Recommended Read: Portfolio Turnover Ratio
Activity Ratios vs Profitability Ratios
Both activity ratios and profitability ratios are basic analytical techniques that assist investors assess various aspects of a company’s financial health. Profitability ratios show how much money a company makes. On the other hand, efficiency ratios show how well it uses its resources to make that money. Analysts can use profitability ratios to compare a company’s earnings to those of its industry competitors. Moreover, these ratios can also be used to analyze the same company’s success over multiple reporting periods.