What are the Types of Activity Ratio?

What is Activity Ratio?

The financial ratios that measure the utility of assets by converting assets into sales are known as activity ratios. These ratios are employed to measure the efficiency with which a firm manages and utilizes its assets. These ratios are also called turnover ratios because they imply how many times assets are turned over into sales within a specific period of time.

The activity ratio is calculated by dividing the net sales by the working capital.

Types of Activity Ratios

The main types of activity ratios are as follows −

  • Inventory Turnover Ratio

  • Debtors Turnover Ratio

  • Assets Turnover Ratios

Let us see each of the ratios in details.

Inventory Turnover Ratio

Inventory Turnover Ratio indicates the efficiency of a company in producing and selling its products in the market.

The inventory turnover ratio is given by −

Equation 1

$$\mathrm{\mathrm{Inventory\: Turnover}\:=\:\frac{\mathrm{Cost\: of \:Goods \:Sold}}{\mathrm{Average\: Inventory}}}$$

The average inventory is the average amount of opening and closing balances of inventory. In the case the company is a manufacturing company, the inventory of finished products is used to calculate the average inventory.

Equation 2

$$\mathrm{\mathrm{Inventory\: Turnover}\:=\:\frac{\mathrm{Sales}}{\mathrm{ Inventory}}}$$

Equation 1 mentioned above is a more appropriate way to measure the inventory turnover. It is so because the items included in it are comparable and can be expressed as costs.

In Equation 2, the numerator is valued at market price and the denominator is valued at cost and they are incomparable. Moreover, average inventory is more appropriate for use than yearly inventory because they fluctuate over the year.

The inventory turnover ratio indicates the rate at which inventory is turned over to receivables via sales. A high inventory turnover implies better management of inventory while a low inventory turnover indicates inefficient conversions of inventory into sales.

Debtors Turnover Ratio

Also known as the Accounts Receivable Turnover Ratio, Debtors Turnover Ratio is achieved by dividing credit sales by average debtors.

Formula 1

$$\mathrm{\mathrm{Debtors \:Turnover\: Ratio}\:=\:\frac{\mathrm{Credit\: Sales}}{\mathrm{Average\: Debtors}}}$$

This ratio indicates the number of times debtors’ turnover within a specified period of time, usually one year. A higher value of debtors' turnover implies better management of credit.

As the figures for credit sales and average debtors may not be available to outsiders, the debtors' turnover can be calculated by the following formula −

Formula 2

$$\mathrm{\mathrm{Debtors \:Turnover}\:=\:\frac{\mathrm{ Sales}}{\mathrm{Debtors}}}$$

One important factor that needs to be calculated is the Average Collection Period (ACP). An average collection period is a measure of the quality of the debtor as it shows the speed of their collection. The shorter the ACP, the better the quality of debtors because it shows prompt payment.

The Average Collection Period (ACP) is given as

$$\mathrm{\mathrm{ACP}\:=\:\frac{360}{\mathrm{Debtors\: Turnover}}\:=\:\frac{\mathrm{Debtors}}{\mathrm{Sales}}\times 360}$$

The average collection period is the time that shows how many days a debtor remains outstanding.

There are two main ways by which the average collection period helps the company.

The two ways are as follows −

  • ACP helps the company in the collectability of debtors and/or increases the efficiency of collections, and

  • ACP helps in determining the comparative strength of a company

Another important term associated with debtors' turnover is the aging schedule. The aging schedule breaks down the debtors in accordance with their outstanding and helps companies keep an eye on the outstanding payments.

Assets Turnover Ratios

Assets turnover ratio shows the relationship between sales and assets.

Net Assets Turnover is given by −

$$\mathrm{\mathrm{Net\: Assets \:Turnover}\:=\:\frac{\mathrm{Sales}}{\mathrm{Net\: Assets}}}$$

As net assets are equal to capital employed, the net assets turnover ratio is also called as the Capital Employed Turnover Ratio.

Generating large amounts of sales is the major objective of companies. As the overall sales are given by sales item, the asset turnover ratio shows the overall performance of the company vis-a-vis its total sales.

Total Assets Turnover is given by −

$$\mathrm{\mathrm{Total\: Assets \:Turnover}\:=\:\frac{\mathrm{Sales}}{\mathrm{Total\: Assets}}}$$

It shows the relationship of sales to total assets. A higher total assets turnover is an indicator of a good mechanism of sales of a company. As it is related to total assets, the total assets turnover ratio projects the sales in a proportion to total sales.

Other types of Assets Turnover Ratios are as follows −

  • Fixed Assets Turnover Ratio

$$\mathrm{\mathrm{Fixed\: Assets \:Turnover\:Ratio}\:=\:\frac{\mathrm{Sales}}{\mathrm{Fixed\: Assets}}}$$

  • Current Assets Turnover Ratio

$$\mathrm{\mathrm{Current\: Assets \:Turnover\:Ratio}\:=\:\frac{\mathrm{Sales}}{\mathrm{Current\: Assets}}}$$

  • Working Capital Turnover Ratio