Activity Ratio

Activity Ratio

• are financial tools used to gauge the ability of a business to convert various asset, liability and capital accounts into cash or sales.
• The faster the business is able to convert its assets into cash or sales, the more efficient it runs.

Advantages

• Activity ratios gauge an organization's operational efficiency and profitability.
• Activity ratios are most useful when compared to competitor or industry to establish whether an entity's processes are favorable or unfavorable.
• Activity ratios can form a basis of comparison across multiple reporting periods to determine changes over time.

DISADVANTAGES (Inventory & Assets Turnover)

• Lost Sales If inventory turns over too quickly, it could negatively affect sales. Merchants may elect to limit the variety of products they carry to prevent a backlog of inventory and keep goods moving through the operation.
• It is Inclusive of Idle Assets ratio could be providing an inaccurate result. Most probably if the idle assets were involved in the production process, the net turnover would be altered which could change the total assets turnover ratio

Types of activity ratio:

• ACCOUNTS RECEIVABLE TURNOVER- determines an entity's ability to collect money from it's customers. Total credit sales are divided by the average accounts receivable balance for a specific period.
• This activity ratio calculates management's ability to receive cash. A low ratio suggests a deficiency in the collection process.

FORMULA

• Accounts receivable turnover = Net Credit Sales/Average Account Receivables
• The net credit sales can usually be found on the company's income statement for the year although not all companies report cash and credit sales separately. Average receivables is calculated by adding the beginning and ending receivables for the year and dividing by two. In a sense, this is a rough calculation of the average receivables for the year.

ANALYSIS

• Higher ratios mean that companies are collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the company collected its average receivables twice during the year. In other words, this company is collecting is money from customers every six months.

INVENTORY TURNOVER

• Measures how often the inventory balance is sold during an accounting period. The cost of goods sold is divided by the average inventory of a specific period.
• A useful way to use this activity ratio is to compare it to previous measures how often the inventory balance is sold during an accounting period.

FORMULA

• Cost of goods sold/ Average inventory.
• The inventory turnover is calculated by dividing the cost of goods sold for a period by the average inventory for that period.
• Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two.

ANALYSIS

• Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys.

TOTAL ASSET TURNOVER

• Total sales are divided by total assets to see how proficient a business is at using its assets.

FORMULA

• Total Asset Turnover= Net Sales/ Average Total Assets.
• Average total assets are usually calculated by adding the beginning and ending total asset balances together and dividing by two. This is just a simple average based on a two-year balance sheet.

ANALYSIS

• Higher turnover ratios mean the company is using its assets more efficiently. Lower ratios mean that the company isn't using its assets efficiently and most likely have management or production problems.

AVERAGE COLLECTION PERIOD

• The average collection period indicates the average length of time (in days) a business must wait before it receives payment from customers who buy merchandise on credit. Below shows how a business would calculate its average collection period ratio.
• Formula: Average Collection Period= Accounts receivable/ Net Sales x 360 days.