What are Activity Ratios?
Definition: Activity Ratios are defined as the financial metrics used to gauge how efficiently company assets are being used to generate optimum revenues and cash. Activity ratios are most useful in the case of comparing two competitive businesses in the same industry.
Activity Ratios are financial metrics that measure the efficiency of the working of a business. It is also known as the “Assets Management Ratio.” These ratios act as a financial metric that helps the business analysts know how a company handles its inventory and maintains operational fluidity.
It can also be used to track a company’s fiscal progress over multiple financial periods. The role of the activity ratio is to evaluate the efficiency of the business by making a careful analysis of the inventories, fixed assets, and accounts receivable.
Importance of Activity Ratios
Activity ratio is essential for a business because of the following reasons:
- It indicates the operating efficiency of the business
- It shows how a company generates revenue and how elements of the business are utilized
- It assists in monitoring the fiscal health of a company over time
Types of Activity Ratios
There are different types of activity ratios that are calculated and constitute a part of the activity ratio. Following are the types of activity ratios:
1. Total Assets Turnover Ratio
The total asset turnover ratio measures the efficiency of the firm in utilizing its assets of the business. The formula for the same is:
Total Assets Turnover Ratio = Sales or Cost of Goods Sold / Total Assets
A high ratio shows that the company is utilizing its assets efficiently in generating sales and vice-versa.
2. Fixed Asset Turnover Ratio
Fixed Assets Turnover ratio is the ratio that shows that how a company is utilizing its fixed assets. The formula for the same is:
Fixed Assets Turnover Ratio = Sales or Cost of Goods Sold / Fixed Assets
A high ratio shows that the company is utilizing its fixed assets efficiently in generating sales and vice-versa.
3. Current Assets Turnover Ratio
Current Assets Turnover ratio is the ratio that shows that how a company is utilizing its Current assets. The formula for the same is:
Current Assets Turnover Ratio = Sales or Cost of Goods Sold / Current Assets.
A high ratio shows that the company is utilizing its Current assets efficiently in generating sales and vice-versa.
4. Working Capital Turnover Ratio
The Working Capital Turnover ratio is the ratio that shows that how efficiently a company is utilizing its working capital for generating sales. The formula for calculating working capital turnover ratio is:
Working Capital Turnover ratio = Sales or Cost of Goods Sold / Working Capital
A high working capital turnover ratio shows that the company properly utilizes the working capital. In contrast, a low ratio means that the business has many debtors, and inventory is unused. The following ratios constitute the part of Working capital:
5. Stock Turnover Ratio
The Stock Turnover ratio is the ratio that highlights the relationship between the inventory and the cost of the goods sold by the business. The stock turnover ratio shows that how fast a company is clearing its inventory in the accounting period. The formula for calculating stock turnover ratio is:
Stock Turnover ratio = Cost of Goods Sold/ Average Inventory.
In this ratio, a high result indicates that the company sells goods quickly and clears the inventory. But a low stock turnover ratio indicates that the goods a company cannot sell the goods quickly and are stored at warehouses for an extended period.
6. Debtor Turnover Ratio
Debtor Turnover ratio shows how good a company is to provide credit facilities to their customer and how easily they recover their credit from the customers in a specified payment period. This ratio is also known as the “Accounts Receivable Turnover Ratio.” The Debtor Turnover Ratio is calculated when credit sales are divided by the average debtors-
Debtor Turnover Ratio = Credit Sales / Average Debtors
A high ratio, in this case, indicates that the credit policies and collection of the company are in a good position. In contrast, a lower ratio means that the company has a weak credit policy.
7. Creditors Turnover Ratio
Creditors Turnover Ratio shows how good a company is in paying the credit amount due to the company in an accounting period. It shows that how many times a company clears off accounts payable in an accounting period. Therefore, it is also called as “Accounts Payable Turnover Ratio.” The Creditors Turnover ratio formula is:
Creditors Turnover Ratio = Net Credit Purchases / Average Creditors.
A high creditor turnover ratio shows that the company can pay all the amount of credit purchases. In contrast, a low ratio indicates that the company is not capable of paying the credit amount.
8. Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is used for determining the ability to collect the money of an entity from its customers.
To calculate account receivables turnover, total credit sales are divided by the average accounts receivable balance for a particular accounting period.
Accounts Receivables Turnover= Net Annual Credit Sales / Average Accounts Receivables
A low Accounts Receivable Turnover ratio would suggest a deficiency in the collection process.
9. Merchandise Inventory Turnover Ratio
The merchandise inventory turnover ratio is used for measuring how often the inventory balance is sold during a particular accounting period. It is a measure of the efficiency of a business in generating sales from its inventory.
To calculate the inventory turnover ratio, the cost of goods sold will be divided by the average inventory for a specific period.
Inventory Turnover Ratio = Cost Of Goods Sold / Average Inventory
A higher ratio here suggests that a company can move its inventory with relative ease.
Activity Ratios Vs. Profitability Ratios
Activity ratios and profitability ratios are both fundamental financial ratios that are used as analytical tools for empowering investors to find out a variety of details regarding the fiscal health of a company.
Activity ratios are used to measure the efficiency of a company to utilize its resources or assets to generate profits while profitability ratios are used to find out the profit generation capability of a company by comparing its profits with other players of the industry.
This was all about what activity ratios are and what their types are. Now, we hope this post would help you in developing a good understanding of different types of activity ratios and their usability.
All in all, these ratios are used to find out how efficient a company is in channelizing its operations by using all the available assets or resources.
What will your definition of activity ratios? Share with us in the comment section below.