Activity Ratios

Activity Ratios Definition

Activity Ratios refers to the type of the financial ratios which are used by the company in order to determine the efficiency with which the company is able to use its different operating assets that are present in its balance sheet and convert the same into the sales or the cash.

Activity ratios help in evaluating a business’s operating efficiency by analyzing fixed assets, inventories, and accounts receivables. It not just expresses a business’s financial health but also indicates the utilization of the balance sheet components.

The most common types of Activity Ratios are as follows –

Activity Ratios

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Activity Ratios (wallstreetmojo.com)

All these ratios quantify the operations of a business using numbers from the business’s current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more or liabilities.

Types of Activity Ratios with Formulas & Examples

Depending on the type of business and to arrive at decisions, various Activity Ratios can be used. Let us now look at activity ratios with formulas and examples.

#1 – Inventory Turnover Ratio

For a business that holds inventory, this activity ratio formula shows how many times the inventory has been sold out completely in one accounting periodOne Accounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more.

Example:

The cost of goods sold for Binge Inc is $10,000, and the average inventoryAverage InventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business.read more cost is $5,000. The Inventory Turnover Ratio is calculated as below:

Activity Ratios Example 1

= $10,000 / $5,000

Inventory Turnover Ratio = 2

It means that the inventory has been sold out twice in a fiscal year. In other words, it takes 6 months for Binge Inc. to sell its entire inventory. Too much cash into inventories is not good for a business; hence, necessary measures need to be taken to increase the inventory turnover ratio.

#2 – Total Assets Turnover Ratio

Total Assets Turnover Ratio calculates the net sales in comparison with its total assets. In other words, it depicts the ability of a business to generating revenue. It helps investors to understand the efficiency of businesses in generating revenue using their assets.

Total Assets Turnover Ratio = Sales / Average Total Assets.
Example:

PQR Inc. generated revenue of $8 billion at the fiscal year-end. The total assets at the start of the year were $1 billion and, at the end of the year, $2 billion.

Average Total Assets = ($1 billion + $2 billion) / 2

= $1.5 billion

Total Assets Turnover Ratio is calculated as below

Activity Ratios Example 2

= $8000000000 / $1500000000

Total Assets Turnover Ratio = 5.33

A higher Total Asset Turnover Ratio depicts the efficient performance of the business.

#3 – Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio measures the efficiency of a business in utilizing its fixed assets. It shows how the fixed assets are being utilized by the business to generate revenue. Unlike the total Assets turnover ratio that focuses on the total assets, the fixed assets turnover ratio focuses only on fixed assets of the business being utilized. When the fixed assets turnover ratio is declining, it is a result of over-investment in any fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more like plant or equipment, to name a few.

Fixed Assets Turnover Ratio = Sales / Average Fixed Assets.
Example:

Net sales of Sync Inc. for the fiscal year were $73,500. At the beginning of the year, the net fixed assets were $22,500, and after depreciation and addition of new assets to the business, the fixed assets cost to $24,000 at the end of the year.

Average Fixed Assets = ($22,500 + $24,000) / 2

Average Fixed Assets= $23,250

Fixed Assets Turnover Ratio is calculated as below

Example 3

= $73,500 / $23,250

Fixed Assets Turnover Ratio = 3.16

#4 – Accounts Receivables Turnover Ratio

Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more Turnover Ratio depicts how good a business is at giving credit to its customers and collecting debts. For calculating the accounts receivables turnover ratio, only the credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more are taken into consideration and not the cash sales. A higher ratio indicates that the being paid by the customers on time, which helps to maintain the cash flow and payment of the business’s debts, employee salaries, etc. on time. It is a good sign when the accounts receivables turnover ratio is on the higher side since the debts are being paid on time instead of writing them off. It shows a healthy business model.

Example:

Roots Inc. is a supplier of heavy machinery spare parts, and all of its customers are major manufacturers, and all of the transactions are carried out on a credit basis. The net credit sale for Roots Inc. for the year ended was $1 million and the average receivables for the year were $250,000.

The accounts receivables turnover ratio can be calculated as below

Example 4

= $1,000,000 / $250,000

Account Receivables Turnover Ratio = 4

It means that Roots Inc. is able to collect its average receivables 4 times a year. In other words, the average receivables are recovered every quarter.

Advantages of Activity Ratios

  • Activity Ratios help in comparison to businesses in the same line of operation.
  • Problem identification can be done using the right Activity Ratios, and necessary corrections in the functioning of the business can be made.
  • Simplifies an analysis by providing the financial data in a simple format, which eventually helps in decision making.
  • Investors can rely on the information that Activity Ratios provide since it is based on numbers and is accurate.

Conclusion

Activity Ratio measures how quickly a business can turn its assets into cash or sales and is a good indicator of how well that business is run. Management and accounting departmentsAccounting DepartmentsThe accounting department looks after preparing financial statements, maintaining a general ledger, paying bills, preparing customer bills, payroll, and more. In other words, they are responsible for managing the overall economic front of the business.read more can use several activity ratios to gauge their business’s efficiency. The most popular ratios are inventory turnover and total assets turnover. It is always recommended to analyze and compare ratios with other businesses in the industry.

This article has been a guide to what is Activity Ratios & its definition. Here we discuss the different types of activity ratios along with its formula and examples. You can learn more about accounting from the following articles –