Understanding Activity Ratios in Finance

# Understanding Activity Ratios in Finance

Rashmi Karan
Manager - Content
Updated on Aug 8, 2024 13:43 IST

This article explores activity ratios and their contribution to effective working capital management. It explains how optimising accounts payable can positively impact a company's liquidity and financial health. Learn through case studies to understand the benefits of aligning activity ratios.

## What are Activity Ratios?

An activity ratio is a financial metric that measures how efficiently a company uses its assets to generate revenue. It calculates a company's ability to convert its investments into sales and earnings. Activity ratios provide valuable insights into a company's operational efficiency, asset management, and inventory turnover. Activity ratios compare a company's performance to other companies in the same industry or its historical performance.

Let us understand activity ratio through an example:

Imagine yourself as an investor looking to make a fruitful investment and looking at two companies in the same industry, Company A and Company B. You want to know which company is more efficient at using its assets to generate revenue. The most efficient way is to compare the two companies' inventory turnover ratios.

The inventory turnover ratio is calculated by dividing a company's cost of goods sold by its average inventory. A higher inventory turnover ratio indicates that the company is selling its inventory more quickly, which means it uses its inventory more efficiently.

In this example, Company A has an inventory turnover ratio of 4, while Company B has an inventory turnover ratio of 2. This data suggests that Company A sells its inventory twice as fast as Company B, meaning Company A is more efficient at using its assets to generate revenue.

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## Types of Activity Ratio

There are different types of activity ratios, as discussed below -

### 1. Total Assets Turnover Ratio

The Total Assets Turnover Ratio is a financial metric measuring how efficiently a company uses its assets to generate sales or revenue. It helps assess how well a company's assets are employed in its core operations. A higher Total Assets Turnover Ratio indicates that a company uses its assets more efficiently.

What It Measures: Total Assets Turnover Ratio shows how efficiently a company uses all its assets to generate sales or revenue.

Formula: Total Assets Turnover Ratio = Total Revenue ÷ Average Total Assets

### 2. Fixed Assets Turnover Ratio

The Fixed Assets Turnover Ratio is a financial metric that evaluates how efficiently a company utilises its fixed assets, such as buildings, machinery, and equipment, to generate sales or revenue. This ratio helps assess a company's effectiveness in generating income from its long-term or non-current assets.

What It Measures: Fixed Assets Turnover Ratio assesses how well a company utilises its fixed assets (like buildings and equipment) to generate revenue.

Formula: Fixed Assets Turnover Ratio = Total Revenue ÷ Average Net Fixed Assets

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### 3. Working Capital Turnover Ratio

The Working Capital Turnover Ratio shows how effectively the company manages its short-term resources to generate sales. A higher ratio means it's using its working capital well.

What It Measures: This ratio evaluates how efficiently a company uses its working capital (current assets minus current liabilities) to support its operations.

Formula: Working Capital Turnover Ratio = Total Revenue ÷ Average Working Capital

### 4. Stock Turnover Ratio

Stock Turnover Ratio tells you how often the company sells and replaces its stock in a given period. A higher ratio suggests efficient inventory management.

• What It Measures: This ratio examines how quickly a company sells its inventory or stock.
• Formula: Stock Turnover Ratio = Cost of Goods Sold (COGS) ÷ Average Inventory

### 5. Debtors or Accounts Receivable Ratio

Debtors or Accounts Receivable Ratio shows how quickly the company turns its sales into cash by collecting from customers. A higher AR turnover ratio indicates that a company is collecting its AR more quickly, while a lower AR turnover ratio indicates it is collecting its AR more slowly.

What It Measures: This ratio assesses how fast a company collects money from its customers who owe it (accounts receivable).

Formula: Debtors or Accounts Receivable Ratio = Total Credit Sales / Average Accounts Receivable

### 6. Creditors or Accounts Payable Ratio

The Creditors or Accounts Payable Ratio, also known as the Accounts Payable Turnover Ratio or the Creditors Turnover Ratio, is a financial metric that assesses how efficiently a company manages its accounts payable.

A higher ratio suggests prompt payment to suppliers.

What It Measures: This ratio measures how quickly a company pays its suppliers or creditors for goods and services received on credit.

Formula: Creditors or Accounts Payable Ratio = Total Credit Purchases ÷ Average Accounts Payable

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If you want to know more about activity ratios in an interesting way, you can go through these videos from experts and learn about the concept.

## Calculation of Activity Ratios - Use Case

Let's look at a practical case for a better understanding of the functionality of these indicators in the organisational structure. We assume that company ABC has the following information as of March 2023:

 Financial data FY 2022-23 Revenue Rs. 23,000,000 Inventory Rs. 54,000,000 Accounts payable Rs. 32,000,000 Sales Rs. 350,000,000 Cost of merchandise sold Rs. 210,000,000

This company wants to optimise its organisational structure. To do this, it applies the formulas of the activity indicators, which yield the following results:

 Indicator Formula Result Inventory turnover (54,000,000x360) ÷ 210,000,000 93 Portfolio turnover (23,000,000x360) ÷ 350,000,000 23 Supplier rotation (32,000,000x360) ÷ 350,000,000 33 Cash cycle (93+23)-33 83

### Implications for Organizational Structure Optimization:

• The inventory turnover days of 93 days suggest room for improvement in inventory management. The company should consider optimising its inventory levels to reduce the time it takes to sell products.
• The positive cash cycle of 83 days indicates a lag between the company's cash outflows (paying suppliers) and cash inflows (from sales and collections). You may want to look closely at the company's working capital management practices.
• The relatively low portfolio turnover days of 23 days are positive, indicating efficient customer collections. However, continuous efforts to expedite customer payments can further enhance cash flow.
• The supplier rotation of 33 days suggests that the company pays its suppliers promptly, a sign of good supplier relationships.

## Why Are Activity Ratios Important?

Listed are some of the reasons why activity ratios are essential for any business -

• Activity ratios assess operational efficiency by examining how a business generates revenue and utilises balance sheet elements.
• Activity ratios help determine how effectively a business generates revenue from its assets and operations.
• These ratios analyse how efficiently a company manages its balance sheet items, such as inventory, accounts receivable, and accounts payable.
• Activity ratios provide insights into a company's operational strengths and weaknesses. They help identify areas for improvement in managing assets, receivables, and payables.

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## Limitations of Activity Ratios

• Activity ratios are based on historical financial data, which may not reflect the company's current performance.
• Activity ratios can vary significantly across different industries, making comparisons difficult.
• Companies can manipulate accounting practices to make their activity ratios appear better than they are.
• Activity ratios can be affected by different accounting standards.
• Activity ratios can indicate problems but cannot identify the underlying causes.

## Conclusion

Activity ratios are fundamental indicators that reveal how efficiently a business operates. They offer insights into revenue generation, balance sheet management, and overall financial performance. Though they come with some limitations, if interpreted cautiously and considered with other financial metrics, activity ratios can provide valuable insights into a company's financial health and performance.

## FAQs - Activity Ratios

What are activity ratios, and why are they essential in financial analysis?

Activity ratios are financial metrics that measure a company's operational efficiency. They are vital because they reveal how effectively a business utilizes its assets to generate revenue and manage cash flow.

What is the ideal range for activity ratios, and how does it vary by industry?

Ideal ranges for activity ratios vary by industry. Businesses must consider their industry, objectives, and prevailing economic conditions when determining the most appropriate range for their specific circumstances. Comparing ratios to industry benchmarks and continuously monitoring and adjusting them can help companies optimize their performance.

How can businesses optimize their activity ratios for improved financial performance?

Optimizing activity ratios involves efficient inventory management, prompt collections, and favourable payment terms with suppliers.

Do activity ratios play a role in working capital management?

Activity ratios, such as accounts payable turnover, are integral to working capital management. They influence liquidity and cash flow.

Are there risks associated with focusing solely on activity ratios in financial analysis?

While activity ratios are valuable, relying solely on them may overlook other important financial aspects. A holistic analysis considers multiple metrics for a complete picture.