Activity Ratios Definition Formula Types Examples

Activity Ratios Definition

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.

When comparing businesses across different industries, activity ratios do not give the desired output.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.read more.Activity ratio formulas also help analysts analyze the business’s current or short-term performance.The ratios depict 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.read more.

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

Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.read moreTotal Assets Turnover RatioFixed 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.read moreAccounts Receivable Turnover Ratio

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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.read more or liabilities.

Types of Activity Ratios with Formulas & Examples

Various activity ratios can be used depending on the type of business and to arrive at decisions. Let us now look at activity ratios with formulas and examples.

#1 – Inventory Turnover Ratio

This activity ratio formula shows how often the inventory has been sold 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.read more for a business that holds inventory.

Inventory Turnover Ratio = Cost of Goods SoldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more / Average Cost of Inventory

The cost of goods sold for Binge Inc. is $10,000, and the average inventoryAverage InventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business.read more cost is $5,000. Therefore, one can calculate the inventory turnover ratio as below: –

= $10,000 / $5,000

Inventory Turnover Ratio = 2

The inventory has been sold out twice in a fiscal year Fiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more. 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.

#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.

PQR Inc. generated revenue of $8 billion at the fiscal year-endFiscal Year-endFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more. 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:

= $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.

#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 assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more like a plant or equipment, to name a few.

Fixed Assets Turnover Ratio = Sales / Average Fixed Assets.

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: –

= $73,500 / $23,250

Fixed Assets Turnover Ratio = 3.16

#4 – Accounts Receivables Turnover Ratio

The accounts receivables Accounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more 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 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. read more 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 Net Credit SalesNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read more / Average Accounts Receivables

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: –

= $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.

Advantages of Activity Ratios

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.

Conclusion

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 Accounting DepartmentsThe accounting department looks after preparing financial statements, maintaining a general ledger, paying bills, preparing customer bills, payroll, and more. In other words, they are responsible for managing the overall economic front of the business.read more 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.