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.
- Activity Ratios do not give the desired output when comparing businesses across different industries.
- The more common term used for activity ratios is efficiency ratiosEfficiency RatiosEfficiency ratios are a measure of how effectively a company manages its assets and liabilities and include formulas like asset turnover, inventory turnover, receivables turnover, and accounts payable turnover..
- Activity ratio formulas also help analysts to analyze the business’s current or short term performance.
- An improvement in the ratios depicts improved profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance..
The most common types of Activity Ratios are as follows –
- Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory.
- Total Assets Turnover Ratio
- Fixed Asset Turnover RatioFixed Asset Turnover RatioThe fixed asset turnover ratio formula determines the ability of a business entity to generate revenue by employing its fixed assets. It is computed as the fraction of net sales and average net fixed assets.
- Accounts Receivable Turnover Ratio
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. 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..
The cost of goods sold for Binge Inc is $10,000, and the average inventory cost is $5,000. The Inventory Turnover Ratio is calculated as below:
= $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.
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
= $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 assets like plant or equipment, to name a few.
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
= $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. 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. 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.
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
= $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.
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 departments 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 –