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Activity ratios are accounting measures of how well a business generates revenue and cash flow from its assets.
Asset efficiency ratios and asset utilization ratios are other names for them. Activity ratios can be used by managers and investors to gauge a company's performance and assess how it stacks up against its competitors or industry norms.
There are different types of activity ratios, depending on the type of asset being measured. Some of the most common activity ratios are:
- Inventory turnover ratio: This ratio indicates the efficiency with which a business sells its inventory. The cost of goods sold divided by the typical inventory is used to calculate it. A corporation with a high inventory turnover ratio often has a healthy market for its goods and effective inventory control. A low inventory turnover ratio could be a sign that a business is dealing with poor demand, outmoded or excess inventory, or problems with pricing.
- Receivables turnover ratio: This ratio gauges how well a business collects receivables from its clients. It is computed by subtracting the average accounts receivable from the net credit sales. A corporation with a high turnover ratio for receivables will have a quick time to collect its debts and a low chance of bad debts. A low ratio of receivables turnover may indicate that a business has unsatisfactory credit policies, ineffective collection practices, or clients who are struggling financially.
- Payables turnover ratio: This percentage illustrates how fast a business pays its suppliers. By dividing the average accounts payable by the cost of products sold, it is determined. A high payables turnover ratio shows that a business pays its vendors promptly and takes advantage of deals or good terms. A low ratio of payables turnover may indicate that a business has issues with cash flow, strained relationships with its suppliers, or unfavorable credit terms.
- Asset turnover ratio: This ratio gauges how effectively a business generates sales using its entire asset base. It is computed by subtracting the average total assets from the net sales. A corporation with a high asset turnover ratio will likely have a lean asset base and high sales. A low asset turnover ratio could indicate that a business has idle or unproductive assets or engages in low-margin business activities.
- Fixed asset turnover ratio: This ratio evaluates how well a business utilizes its fixed assets, such as property, plant, and equipment, to produce sales. Divide the net sales by the average net fixed assets to arrive at this number. An organization that has a high fixed asset turnover ratio is one that has a high return on its fixed asset investment. If a corporation has a low fixed asset turnover ratio, it may be a sign that it has overinvested in these assets, or that they have depreciated or been damaged.
Activity ratios can give important information about a company's profitability and operational effectiveness. These should, however, be utilized in conjunction with other financial statistics and indicators rather than in isolation. The benchmarks or averages for the industry should also be used to compare them, as different industries may have varying standards and expectations for activity ratios.
