Activity ratios measure a company’s ability to convert assets and liabilities into cash or sales. The faster it is able to do this, the more efficiently it is operating.
Types of Activity Ratios
Conmanly used Activity Ratios are
- Total Asset Turnover
- Fixed Asset Turnover
- Working Capital Turnover
- Receivables Turnover
- Inventory Turnover
- Payable Turnover
Total Asset Turnover
It measures how efficiently a company uses all its assets to generate revenues. It is defined as net revenues divided by average total assets.
Total Asset Turnover = Net Revenue / Average Total Assets
Net Revenue (Net Sales) equals gross revenue minus Sales Returns. A sales return is merchandise sent back by a buyer to the seller. Reason of return could be one of the following
- Excess quantity shipped/ Ordered
- Defective goods
- Product specifications are incorrect
- Wrong items shipped
Average fixed assets balance can be calculated by dividing the sum of fixed assets carrying amounts at the start and end of the period divided by 2.
Drop in total asset turnover may be indicative of investing in more assets, with an eye towards future growth.
Fixed Asset Turnover
It is similar to the total asset turnover, but specifically measures how efficiently a company uses its fixed assets to generate revenues. It is defined as net revenues divided by average fixed assets.
Fixed Assets Turnover = Net Revenue / Average Fixed Assets
Working Capital Turnover
It is defined as the ratio of revenues to average net working capital. Working capital measures a company’s operating liquidity.
Working Capital Turnover = Revenue / Average Net Working Capital
Net Working Capital is the difference between a company’s current assets and current liabilities on its balance sheet. It is a measure of a company’s ability to meet short-term obligations, as well as fund operations of the business.
Net Working Capital = Current Assets – Current Liabilities or Net Working Capital = Accounts Receivable + Inventory – Accounts Payable
First formula above includes all accounts, the second formula only includes three accounts. Accounts Payable is generated when a company purchases goods or services from its suppliers on credit. It is expected to be paid off within a year’s time, or within one operating cycle (whichever is longer).
It measures how soon sales will become cash. It is defined as the ratio of net credit sales of a business to its average accounts receivable during a given period. Receivables Turnover estimates the number of times a business collects its average accounts receivable balance during a period.
Receivables Turnover = Net Credit Sales / Average Accounts Receivable
Net Credit sales refer to a sale in which the amount owed will be paid at a later date. Net credit sales are those revenues generated by an entity that it allows to customers on credit, less all sales returns and sales allowances. Sales Allowances is reduction in the price charged to a customer, due to a problem with the sale transaction not involving the delivered goods or service. We can obtain the net credit sales figure from the income statement.
Net Credit Sales = Sales on Credit – Sales Returns – Sales allowances
Accounts receivable is the amount owed to a company resulting from the company providing goods and/or services on credit. It can be found on the balance sheet.
It measures how soon a company’s inventory is being sold. It is defined as the ratio of COGS to average inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventories
Cost of goods sold figure is reported on income statement. Inventories appear on balance sheets. Inventory is a current asset consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated.
It is the ratio of a company’s net credit purchases to average accounts payable. Dividing 365 by the payable turnover gives days payable outstanding.
Payable Turnover = Net Credit Purchases / Average Accounts Payable
In some cases, cost of goods sold (COGS) is used in the numerator in place of net credit purchases.