What are Activity Ratios?
Activity ratios are financial metrics used to gauge how efficient a company’s operations are. The term can include several ratios that can apply to how efficiently a company is employing its capital or assets.
Activity ratios are useful for comparing how a company’s performance is trending over time in a horizontal statement analysis or how a company’s performance fares against its peers in comparable company analysis. They are also known as turnover ratios or operating efficiency ratios.
Categories of Activity Ratios
Activity ratios are classified into three main categories:
1. Working Capital
Working capital, also referred to as operating capital, is the excess of current assets over current liabilities. The level of working capital provides an insight into a company’s ability to meet current liabilities as they come due. Achieving a positive working capital is essential; however working capital should not be too large in order to not tie up capital that can be used elsewhere.
There are three main components of working capital are:
The three accounts are useful in determining the cash conversion cycle, an important metric that measures the time in days in which a company can convert its inventory into cash.
The accounts receivable turnover measures how efficiently a company is able to manage its credit sales and convert its account receivables into cash.
Receivables Turnover = Revenue / Average Receivables
A high receivables turnover signals that a company is able to convert its receivables into cash very quickly, whereas a low receivables turnover signals that a company is not able to convert its receivables as fast as it should.
The Days of Sales Outstanding (DSO) measures the number of days it takes to convert credit sales into cash.
Days of Sales Outstanding = Number of Days in Period / Receivables Turnover
Inventory turnover measures how efficiently a company is able to manage its inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventory
A low inventory turnover ratio is a sign that inventory is moving too slowly and is tying up capital. On the other hand, a company with a high inventory turnover ratio can be moving inventory in a rapid pace; however, if the inventory turnover is too high, it can lead to shortages and lost sales.
Days of Inventory on Hand (DOH) measures the number of days it takes to sell inventory balance.
Days of Inventory on Hand = Number of Days in Period / Inventory Turnover
Payables turnover measures how quickly a company is paying off its accounts payable to creditors.
Payables Turnover = Cost of Goods Sold / Average Payables
A low payables turnover can indicate either lenient credit terms or an inability for a company to pay its creditors. A high payables turnover can indicate that a company is paying creditors too fast or it is able to take advantage of early payment discounts.
Days of Payables Outstanding (DPO) measures the number of days it takes to pay off creditors.
Days of Payables Outstanding = Number of Days in Period / Payables Turnover
Cash Conversion Cycle
As noted earlier, the cash conversion cycle is an important metric in determining how efficiently a company can convert its inventories into cash. Companies want to minimize their cash conversion cycle so that they receive cash from sales of inventory as quickly as possible. The metric indicates the overall efficiency of a company’s working capital/operating assets’ utilization.
Cash Conversion Cycle = DSO + DIH – DPO
2. Fixed Assets
Fixed assets are non-current assets and are tangible long-term assets that are non-operating, i.e., not used in the day-to-day activities of a company. Fixed assets usually refer to tangible assets that are expected to provide an economic benefit in the future, such as, property, plant, and equipment (PPE), furniture, machinery, vehicles, buildings, and land.
Fixed Assets Turnover measures how efficiently a company is using its fixed assets.
Fixed Asset Turnover = Revenue / Average Net Fixed Assets
A high ratio indicates that a company may need to invest more in capital expenditures (capex), and a low ratio may indicate that too much capital is tied up in fixed assets.
3. Total Assets
Total assets refer to all the assets that are reported on a company’s balance sheet, both operating and non-operating (current and long-term). Total asset turnover is a measure of how efficiently a company is using its total assets.
Total Assets Turnover = Revenue / Average Total Assets
A high ratio indicates that a company is using its total assets very efficiently or that it does not own many assets, to begin with. A low ratio indicates that too much capital is tied up in assets and that assets are not being used efficiently in generating revenue.
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