What are Activity Ratios?

Activity ratios measure how well an organization uses its assets to generate revenue. A well-managed organization minimizes its use of receivables, inventory, and fixed assets while still generating the largest-possible amount of revenue. Analysts use activity ratios to gain an outsider’s view of how well an organization’s management team is using its assets; this analysis can result in recommendations to alter investor holdings in a targeted business. The most common activity ratios are noted below.

Best Practices for Activity Ratios

It is best to plot the activity ratios for a business on a trend line, to see if there are long-term changes in how well assets are being managed. The best-managed corporations show an ongoing, gradual improvement in these ratios, as management finds more ways to enhance the capabilities of the business. Another best practice is to compare these trend lines to those of competing firms, to benchmark a company’s performance. Yet another best practice is to carefully define how the various activity ratios are measured, so that they can be consistently calculated over time, without any anomalies due to incorrect measurements.

Receivables Turnover Ratio

The receivables turnover ratio is useful for reviewing the speed with which an organization’s trade accounts receivable are being collected. This collection speed is based on the quality of its customers (which involves customer screening by the credit department), as well as the accuracy of its invoices and the effectiveness of its collection staff. The ratio is calculated as credit sales divided by average accounts receivable. Thus, the receivable turnover formula is:

Net annual credit sales ÷ ((beginning receivables + ending receivables) / 2) = Receivable turnover

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Inventory Turnover Ratio

The inventory turnover ratio is the cost of goods sold divided by average inventory. Thus, the inventory turnover formula is:

Annual cost of goods sold ÷ Inventory = Inventory turnover

There are many ways to achieve a high turnover ratio, including selling only a small number of stock keeping units, using a just-in-time production system, and rapidly selling off unused raw materials and finished goods at discounted prices.

Fixed Asset Turnover Ratio

The fixed asset turnover ratio is sales divided by average fixed assets. Thus, the fixed asset turnover formula is:

Net annual sales ÷ (Gross fixed assets - Accumulated depreciation) = Fixed asset turnover ratio

A high ratio can be achieved by outsourcing production work, keeping minimal excess equipment on hand, and increasing the utilization rate of existing equipment. However, it can be difficult to reduce this investment in certain industries. For example, an oil refinery will always require a substantial fixed asset investment.

Payables Turnover Ratio

The payables turnover ratio is total purchases from suppliers divided by average accounts payable. Thus, the payables turnover formula is:

Total supplier purchases ÷ ((Beginning accounts payable + Ending accounts payable) / 2)

This turnover rate can be improved by negotiating longer payment terms with suppliers. Realistically, only a large firm has the purchasing heft to negotiate significant improvements in payment terms.

Advantages of Activity Ratios

There are several advantages to including activity ratios in your analysis of a business. These advantages are as follows:

Identify problem areas. Activity ratios are an easy way to determine which general areas of the balance sheet are worth more detailed investigation, thereby narrowing the focus of management.
Enhanced asset usage. By reviewing activity ratios in detail, you can spot assets that are not being used efficiently, and work to improve this usage. The result may be a reduction in the amount of assets needed to support company operations.
Benchmarking analysis. Activity ratios can be used to benchmark company performance against competitors, which also shows management where the firm can enact improvements.
Investment analysis. Investors can use activity ratios to analyze whether a business is sufficiently well run to be worthy of their investment in it.

Problems with Activity Ratios

A possible concern with emphasizing activity ratios is that management could run a business excessively lean, giving it no room to respond when there is a crisis. This is a particular concern with fixed assets, where it can make sense to keep excess capacity on hand to guard against demand spikes and the failure of other equipment.