Activity Ratios

Updated on May 7, 2024
Article byAbhilash Ramachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Activity Ratios?

Activity ratios refer to the type of financial ratios the company uses to determine the efficiency with which it can use its different operating assets in its balance sheet and convert them into sales or cash.

Activity Ratios

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Activity ratios help evaluate a business’s operating efficiency by analyzing fixed assets, inventories, and accounts receivables. It expresses a business’s financial health and indicates the utilization of the balance sheet components.

Key Takeaways

  • Activity ratios are essential tools for evaluating a company’s operational efficiency in utilizing its operating assets to generate sales or cash.
  • Commonly employed activity ratios encompass the inventory turnover ratio, total assets turnover ratio, fixed asset turnover ratio, and accounts receivable turnover ratio.
  • Among the various activity ratios, inventory turnover and total assets turnover are particularly popular and widely employed in assessing a company’s performance. These ratios show how efficiently inventory is managed and how effectively assets are utilized to generate revenue.

Activity Ratios Explained

Activity Ratios are those financial metrics that help in evaluating upto what extent the business is able to use its assets to generate revenue. It gives an insight into the efficient level of the company and its future prospects in the competitive market.

There are many types of such financial activity ratios that the widely used for assessment of company performance as elaborated in the article below. They are important for both management aand stakeholders of the company who take decisions regarding investment in the business. Analysts and finance professionals frequently use them to form their opinion about the business which contributes to investment decisions taken by them on behalf of their clients.

When comparing businesses across different industries, activity ratios do not give the desired output.

The more common term used for activity ratios is efficiency ratios.

Activity ratio formulas also help analysts analyze the business’s current or short-term performance.

The ratios depict improved profitability.

The most common types of activity ratios are as follows: –

All these ratios quantify the operations of a business using numbers from the business’s current assets or liabilities.

The above ratios provide various types of important information regarding efficiency in payment to suppliers and collection from customers, how well the inventory of the business is managed and the assets are utilized to generate sales and revenue, usage of fixed assets like land, plant, machinery, and how much effective they are in generating sales for the business.

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Types

Various activity ratios can be used depending on the type of business and to arrive at decisions. Let us now look at the list of activity ratios as given below.

#1 – Inventory Turnover Ratio

This activity ratio formula shows how often the inventory has been sold completely in one accounting period for a business that holds inventory.

Inventory Turnover Ratio = Cost of Goods Sold / Average Cost of Inventory

#2 – Total Assets Turnover Ratio

The total assets turnover ratio calculates the net sales compared to its total assets. In other words, it depicts a business’s ability to generate revenue. It helps investors understand the efficiency of companies in generating revenue using their assets.

Total Assets Turnover Ratio = Sales / Average Total Assets.

ss.

#3 – Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures the efficiency of a business in utilizing its fixed assets. It shows how the company uses fixed assets to generate revenue. Unlike the total assets turnover ratio, which focuses on the total assets, the fixed assets turnover ratio focuses only on the business’s fixed assets. Therefore, when the fixed assets turnover ratio declines, it results from over-investment in any fixed assets like a plant or equipment, to name a few.

Fixed Assets Turnover Ratio = Sales / Average Fixed Assets.

#4 – Accounts Receivables Turnover Ratio

The accounts receivables turnover ratio depicts how good a business is at giving credit to its customers and collecting debts. Calculating the accounts receivables turnover ratio only considers the credit sales are considered and not cash sales. A higher ratio indicates 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. It is a good sign when the accounts receivables turnover ratio is higher since the debts are paid on time instead of written off. It shows a healthy business model.

Account Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivables.

All the above information regarding financial activity ratios is essential in order to interpret how well the business is running and whether it has good future prospects. If they above ratios provide a positive outlook for the business, it is assumed that the business is sustainable and profitable. It will successfully attract investors and shareholders. Good financial results will increase stock prices and create a positive image of the company in the competitive market.

Examples

Let us study the concept of list of activity ratios with the help of some suitable examples.

Example#1

The cost of goods sold for Binge Inc. is $10,000, and the average inventory cost is $5,000. Therefore, one can calculate the inventory turnover ratio as below: –

Activity Ratios Example 1

= $10,000 / $5,000

Inventory Turnover Ratio = 2

The inventory has been sold out twice in a fiscal year. In other words, it takes six months for Binge Inc. to sell its entire inventory. Too much cash in inventories is not good for a business. Hence, one must take necessary measures to increase the inventory turnover ratio.

Example#2

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

= $8,000,000,000 / $1,500,000,000

Total Assets Turnover Ratio = 5.33

A higher total asset turnover ratio depicts the efficient performance of the business.

Example#3

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. Moreover, after depreciation and new assets addition to the business, the fixed assets cost $24,000 at the year-end.

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

Average Fixed Assets= $23,250.

One must calculate the fixed assets turnover ratio as below: –

Example 3

= $73,500 / $23,250

Fixed Assets Turnover Ratio = 3.16

Example#4

Roots Inc. is a supplier of heavy machinery spare parts. All its customers are major manufacturers, and all transactions carry 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.

One can calculate the accounts receivables turnover ratio as below: –

Example 4

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

Account Receivables Turnover Ratio = 4

Roots Inc. can collect its average receivables four times a year. In other words, the average receivables recover every quarter.

Purpose

The above ratios have a very close relationship with every business and depicts a very clear picture of its past performance, current situation and future prospects. Let us learn their purpose in details.

  • Efficiency evaluation – It helps in evaluating the efficiency of the company in resource utilization, cost control and performance potential. It gives an idea about how well the day to day operation is carried out and assets are managed without much wastage and increase in cost.
  • Working capital management – the ratios provide an insight into the working capital management of the business, which are current liabilities and assets. If this is positive then it is assumed that the liquidity and cash flow position is favorable.
  • Payment management – Payment related to suppliers should be managed effectively so that there is no delay but no excess outflow of cash before time. The ratios help in tracking whether there are payment delays leading to penalty charges which are extra cash outflow. It is also important to note the credit period is enough to use the money to meet other pending obligations.
  • Identify trends – There ratios help in identifying the financial trends of the business in terms of is capability in finance management, performance evaluation. The trends are useful in taking management decisions regarding production planning, budgeting, resource allocation in terms of financial capital and labor, etc.
  • Comparison – They are very useful financial metric for comparison between peer companies and also internal comparison on a quarterly or yearly basis. These comparisons can be used as a benchmark for performance evaluation and devise strategies to survive successfully among competotors in the market.
  • Financial Analysis – The financial analysis is an important requirement for planning different approaches in various departments and creating provisions for funds and budgeting to meet various business requirements, be it the usual day to day needs or unforeseen contingencies.
  • Detect problem areas – Since these ratios provide an insight into the performance of the company, they can also detect problems in operational process. It is very important to identify these problems and design strategies to solve them before they escalate and affect the business in a negative way.

Thus, the above are some purposes or uses of activity ratios in every business. Analysts and investor as well as the company management pay special attention to them so that these ratios always exibit a positive result and the business can operate in a healthy, cost effective, and useful manner.

Advantages

Some noteworthy advantages of the ratios are as given below.

  • Activity ratios help compare businesses in the same line of operation.
  • One can make the problem identification using the right activity ratios. It can make necessary corrections in the functioning of the business.
  • Simplifies an analysis by providing the financial data in a simple format, which eventually helps make decisions.
  • Investors can rely on activity ratios’ information since it is accurate and based on numbers.

The activity ratio measures how quickly a business can turn its assets into cash or sales and is a good indicator of its run. Management and accounting departments can use several activity ratios to gauge their efficiency. The most popular ratios are inventory turnover and total assets turnover. It always recommends analyzing and comparing ratios with other businesses in the industry.

Frequently Asked Questions (FAQs)

1. What are the applications of activity ratio?

Activity ratios, also known as efficiency ratios, measure a company’s effectiveness in managing its assets and generating revenue. They provide insights into the operational efficiency and productivity of a company. Some common activity ratios include inventory turnover ratio, accounts receivable turnover ratio, and total asset turnover ratio.

2. What is the liquidity ratio vs. activity ratio?

Liquidity ratios assess a company’s ability to meet its short-term obligations, focusing on its liquidity and ability to convert assets into cash. On the other hand, activity ratios evaluate how efficiently a company utilizes its assets to generate sales or revenue. While liquidity ratios emphasize solvency, activity ratios focus on operational efficiency and asset management.

3. What are the limitations of the activity ratio?

Activity ratios have certain limitations. They provide a snapshot of performance and may not reflect long-term trends. Different industries have different asset utilization patterns, making comparing activity ratios across sectors challenging. Additionally, activity ratios rely on financial statements, which can be subject to manipulation or inaccuracies. It’s essential to interpret activity ratios alongside other financial metrics for a comprehensive assessment.

This article is a guide to what are Activity Ratios. We explain their types along with examples, purpose, and their advantages. Also, you can learn more about accounting from the following articles: –