What’s it: Activity ratio is a financial ratio to measure how well a company manages its assets. We then relate it to revenue or expenses to pay suppliers. Some are useful for assessing a company’s effectiveness in managing short-term assets (working capital), while others assess long-term asset utilization. Also known as asset utilization ratio or operating efficiency ratio.
Why is the activity ratio important?
Activity ratios are important to measure company performance, in addition to profitability, liquidity, and solvency ratios. Specifically, they give us insight into how efficient and effective a company manages and generates cash and revenue using its assets.
Ratios are useful when we compare companies in the same industry. We can have an idea and understanding of why a company is superior to its competitors.
Also, comparing the same ratio over time is another way to gain deeper insight. For example, we can track how effective management’s strategies and efforts manage the business and make money.
Both approaches – comparisons with peers and over time – are important in drawing more objective conclusions and assessments.
What are some examples of activity ratios, and how to calculate and interpret them?
Calculating the activity ratio is relatively easy. We only need arithmetic operations. We divide the accounts on the income statement by the balance sheet accounts. Some are already available there. However, for other metrics, we may have to calculate manually, such as purchases. Here are the activity ratios we covered:
- Inventory turnover
- Days of inventory on hand (DOH)
- Accounts receivable turnover
- Days sales outstanding (DSO)
- Accounts payable turnover
- Days payable outstanding (DPO)
- Working capital turnover
- Fixed asset turnover
- Total asset turnover
Inventory turnover measures how well a company manages inventory, measured by its success in converting it into sales within a year.
To calculate it, we need two accounts: cost of goods sold (COGS) and inventory. We can find it in the income statement and balance sheet. Then, we divide COGS by the average inventory for the last two years. The mathematical formula for inventory turnover is as follows:
- Inventory turnover = COGS / Average inventory
Higher ratios are preferred as they indicate effective inventory management. This is because the company is relatively quick to convert its inventory into sales.
On the other hand, a low ratio indicates less effective inventory management. As a result, the company is slow in converting inventory into sales. As a result, expenses are likely to increase as inventory builds up.
But, we need to note, why this ratio is high or low can also occur for other reasons. For example, a high ratio could also be due to insufficient inventory. In addition, the company faces strong market demand. But, it is not accompanied by adequate production planning.
Under such conditions, more supplies are sold than replenished. Thus, when demand is still high in the future, the company misses the opportunity to boost sales due to insufficient supply and production.
To better understand the reasons for this change in ratio, we can look at sales trends by the company and industry. It gives us insight into whether the high ratio is due to high demand or insufficient supply.
Days of inventory on hand
Days of inventory on hand (DOH) are inversely related to the inventory turnover ratio. And it shows us how many days, on average, the company converts inventory into sales.
To calculate DOH in a given year, we divide the number of days in a year (365 days) by the inventory turnover ratio. Here is the DOH formula:
- DOH = 365 / Inventory turnover
A lower DOH is preferable because it indicates a high inventory turnover. And, the company needs fewer days to convert inventory into sales. For example, if the value is 90, it takes 90 days to generate sales from available inventory.
Please remember, ratios don’t tell us how long it took the company to raise money. The company may recognize revenue as it occurs even though it has not yet received cash payments. In this case, the company recognizes revenue in the income statement. And, at the same time, the company did not record an increase in cash but accounts receivable.
Accounts receivable turnover
Accounts receivable turnover measures how effectively a company manages credit sales. When selling credit, accounts receivable appear. This is because the company accepts cash payments not on the day the goods are delivered but several days after. Thus, before receiving cash payments, the company reports accounts receivable on the balance sheet and revenue on the income statement. Then, after the company received payment, cash increased, and accounts receivable decreased at the same amount.
Sometimes, customers pay on time. But, other times, the company has to charge them. In fact, it could lead to bad debts, which means the company is less likely to collect money from customers.
And the accounts receivable turnover ratio gives us insight into how effectively the company manages it all. We measure it by dividing revenue by the average accounts receivable.
- Accounts receivable turnover= Revenue / Average accounts receivable
A higher ratio indicates effective accounts receivable management. The company can quickly collect cash payments from customers. Two reasons may explain it. First, the company’s credit collection procedures and policies are effective. Second, credit terms or billing policies are strict.
The second reason can be problematic if, at the same time, competitors offer more lax terms. It can shift customer demand from the company to competitors.
Days sales outstanding
Days of sales outstanding (DSO) is inversely proportional to accounts receivable turnover. It measures how many days, on average, the company collects cash payments from customers. We calculate it by dividing the number of days in a year (365 days) by the accounts receivable turnover ratio.
- DSO = 365 / Accounts receivable turnover
Please remember, the above formula assumes we are using one year’s sales figures when calculating the accounts receivable turnover ratio. Therefore, we use 365 days. It will be different if we calculate the quarterly or semiannual figures.
A lower DSO is preferable as it indicates a faster collection of cash. Say, a DSO of 60 means, on average, it takes the company 60 days to collect cash payments from customers.
Accounts payable turnover
Accounts payable turnover shows how many times the company pays suppliers in one year. It is the opposite of accounts receivable turnover.
The company records account payable when buying from suppliers on credit. This is because the company has received goods or services but has not paid for them. Thus, it results in an obligation to pay.
We calculate the accounts payable turnover ratio by dividing purchases by the average accounts payable.
- Accounts payable turnover = Purchases / Average accounts payable
Accounts payable is in the current liabilities section of the balance sheet. Meanwhile, we must calculate the purchase data manually because it is not presented in the financial statements. We calculate it by the following formula:
- Purchases = Ending inventory + Cost of goods sold – Beginning inventory
If without bad consequences, a lower ratio is more desirable because the company pays suppliers longer. It can allocate the money for other purposes before paying it to the supplier.
Meanwhile, if the ratio is higher, the company spends money faster. It could be because:
- The company is trying to get relief facilities offered by suppliers, such as discounts for paying earlier.
- The company cannot take full advantage of suppliers’ lenient credit terms and pay suppliers more quickly.
- The supplier’s credit terms are strict.
If the ratio is high for the first reason, it shouldn’t be a problem.
Days payable outstanding
Days payable outstanding (DPO) tells us how many days, on average, a company pays its suppliers. It is the opposite of accounts payable turnover. We calculate it by dividing the number of days in a year by the accounts payable turnover. Here’s the formula:
- Days payable outstanding (DPO) = 365 / Accounts payable turnover
The lower the DPO, the faster the company pays suppliers. And, for example, if it’s 60, it shows, on average, the company pays its suppliers within 60 days.
A low DPO could be due to the supplier’s strict credit terms. Or, the company may try to take a discount offered by a supplier if paying early.
Working capital turnover
Working capital turnover measures how well a company manages its working capital to generate revenue. To calculate it, we divide revenue by working capital. Meanwhile, to get the working capital figure, we have to calculate it manually. We get it by subtracting current liabilities from current assets. The working capital turnover formula is as follows:
- Working capital turnover = Revenue/ Average working capital
A higher ratio is preferable because it indicates efficient working capital management in generating revenue. Conversely, if it is lower, the management of working capital is less efficient. And, in general, a high ratio helps smooth operations and limits the need for additional funds to finance working capital.
Fixed asset turnover
Fixed asset turnover measures the company’s efficiency in using fixed assets to earn revenue. We calculate it by dividing revenue by the average fixed assets in the last two years.
We can see fixed assets in the non-current assets section of the balance sheet. Companies may present them as property, plant, and equipment (PP&E).
- Fixed asset turnover = Revenue / Average fixed assets
A higher ratio is desirable because it shows the company is more efficient in using fixed assets to generate revenue. Conversely, a low ratio usually indicates operating inefficiency.
However, the ideal ratio will also depend on the industry in which the company operates. For example, in capital-intensive industries, companies rely heavily on fixed assets such as machinery and equipment.
In addition, the ratio also depends on how long the company has been operating. The new company has newer fixed assets, so its accumulated depreciation is lower than the older assets. Thus, the book value – which we used as the divisor in the above formula – will be higher.
Asset turnover measures the overall operating efficiency. It tells how well the company is managing its assets to generate revenue. To get it, we divide revenue by the average total assets in the last two years. Here’s the formula for the asset turnover ratio:
- Asset turnover = Revenue/ Average total assets
A higher ratio is more desirable because it shows the company is more efficient in managing its assets. Conversely, a lower ratio underscores a less efficient operation in generating revenue.
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