What is an activity ratio?
In accounting,[1] activity ratios, commonly known as efficiency ratios, are used to determine how efficiently a business utilises and manages its resources (assets) to generate revenues and cash.
Put differently, the different types of activity ratios indicate a business’s ability to change different types of assets, such as inventory, accounts receivable, or fixed assets, into revenues.
Activity ratios are also known as utilisation ratios, asset management ratios, or performance ratios.
Types of activity ratios
There is a variety of activity ratios that can be classified into three main categories namely: working capital, fixed assets, and total assets.[2]
Working capital
Working capital, also known as operating capital, refers to the amount of cash a business can use in its day-to-day trading operations. It is determined by subtracting the business’s current liabilities from its current assets.
Examples of current liabilities are bank overdrafts and accounts payable, while current assets include items such as cash and accounts receivable. Generally, current assets are highly liquid, meaning they can be easily converted into cash.
Working capital turnover ratio
- What the ratio measures
The working capital turnover ratio, also referred to as the working capital ratio, measures how effectively a business utilises its working capital.
A high working capital ratio indicates that a company is efficiently utilising its current assets and current liabilities for supporting sales.
Conversely, a low working capital ratio could be a sign of bad debts or outdated inventory.
Working capital ratios vary from industry to industry. Hence, it is beneficial for a business to compare its ratio with those of competitors in the same industry.
- Formulas
There are two formulas that can be used to calculate the working capital ratio of a business.
- Formula 1
Working capital ratio = Current assets/Current liabilities
This is the standard formula to calculate the working capital ratio.
- Example 1
The current assets of company Good Times total R220 000 for the financial year and its current liabilities are R170 000.
The working capital ratio of company Good Times will look as follows:
R220 000/R170 000
= 1.29%.
The result implies that for every R1 the company has in current liabilities, the company has R1.29 in current assets available.
- Formula 2
Working capital ratio = Net sales/Working capital
- Example 2
Company CZN reported net sales of R2 500 000 for the financial year and its working capital was calculated at R500 000.
The company’s working capital ratio will look as follows:
R2 500 000/R500 000
= 5
The result of 5 indicates that company CZN generated R5 of sales for every R1 of the working capital used.
Other activity ratios categorised under working capital
Working capital entails three major components, encompassing the following accounts: inventory, accounts receivable (receivables), and accounts payable (payables).
There is a variety of activity ratios concerning a company’s inventory, receivables, and payables which will be discussed below.
Cash conversion cycle (CCC)
- What the cash conversion cycle indicates
The cash conversion cycle (CCC), also called the cash cycle, is an accounting tool that measures the amount of time it takes a business to convert its outlay on inventory into cash.
Companies aim to minimise their cash conversion cycle in order to receive cash from sales of inventory as quickly as possible, enabling them to utilise the cash for ongoing or urgent operations.
The CCC of a business indicates how efficiently it utilises its working capital.
- Formula
Cash conversion cycle = DIO + DSO – DPO
Where:
DIO = Days of inventory outstanding.
DSO = Days sales outstanding.
DPO = Days of payables outstanding.
- Example
Company XXX is a manufacturing company that pays its suppliers (creditors) within 35 days. The company manages to keep enough inventory at hand for 55 days of sales and its debtors take 50 days on average to pay their accounts.
Company XXX’s cash conversion cycle will look as follows:
55 days + 50 days – 35 days
= 70 days
The result of 70 days means that company XXX will need on average 70 days of working capital to convert purchased inventory into cash.
Inventory
Regarding businesses, inventory refers to all the products, goods, items, merchandise, and materials held by a business to sell to customers. Inventory can include finished items ready for sale, items in the process of production, and items that will be used in the producing process of items that can be sold.
Inventory turnover ratio
- What the ratio indicates
The inventory turnover ratio is an important tool for retail businesses, enabling them to determine how efficient its inventory is managed.
Say in other words, the inventory turnover ratio calculates how often a business’s inventory balance is sold during a specific accounting period, for example six-months or a year.
There are no specified guidelines for inventory turnover ratios. It is a useful metric for a business to compare its inventory management with other competitors in the same industry.
Generally, a high inventory turnover ratio indicates satisfactory inventory management and a higher demand for a specific product. However, a too high inventory turnover can cause shortages and eventually lost sales.
Contrarily, a low ratio may signal insufficient marketing, a decreasing demand for a product, or overstocking, which implies that capital is tied up.
An increase in the inventory rate leads to an increase in net profit, and vice versa.
- Similar terms
The inventory turnover ratio is also called the merchandise inventory turnover ratio or the inventory utilisation ratio.
- Formula
Inventory turnover ratio = Cost of sales/Average inventory
In the calculation, sales are included at cost price because inventory is generally valued at cost. Cost of sales is also known as cost of goods sold (COGS).
Concerning inventory, the average inventory is calculated by adding the opening and closing inventory balances of the specific accounting period together and dividing the sum by two.
If the opening inventory balance is not available, then only the closing balance of inventory is used.
- Example
Company SFG reported an annual cost of sales of R1 250 000. The opening and closing balances of its inventory were respectively R250 000 and R220 000. Thus, the average inventory for the particular financial year was R235 000 ((R250 000 + R220 000)/2).
SFG’s inventory turnover ratio = R1 250 000/R235 000
= 5.32 times.
The answer of 5.32 times indicates that company SFG’s inventory turned over 5.32 times during the past financial year.
Days of inventory ratio
- What the ratio indicates
The days of inventory ratio, is closely related to the inventory turnover ratio, indicating how many days on average a business is storing inventory. Put differently, this ratio measures the average number of days it takes a firm to sell inventory items since purchasing them.
Efficient inventory management entails stocking as little inventory as possible while ensuring that enough inventory is consistently available to meet customers’ demands.
The general rule applied by a business is to sell its inventory just as quickly or quicker as your competitors do.
- Similar terms
The days of inventory ratio is also referred to as days of inventory on hand (DOH) or days in inventory.
- Formulas
To determine the number of days it takes a business to sell its inventory, different formulas can be used. The information of company SFG will also be used in the formulas and examples below.
- Formula 1
Days of inventory ratio = (Average inventory/Cost of sales) x 365
- Example 1
(R235 000/R1 250 000) x 365
= 0.19 x 365
= 68.62 days.
This means that company SFG sells its entire inventory within a 69-day period.
- Formula 2
Days in inventory = (1/Inventory turnover ratio) x 365
- Example 2
(1/5.32) x 365
= 0.28 x 365
= 68.61 days.
- Formula 3
Days of inventory on hand (DOH) = Number of days in period/Inventory turnover ratio
- Example 3
365/5.32
= 68.61 days.
Accounts receivable
Accounts receivable, also referred to as receivables, is the amount of money owed to a business by its customers (debtors) for goods or services sold on credit accounts. Express differently, receivables represent debt payable by a firm’s customers for goods or services that have already been delivered or used.
Accounts receivable turnover ratio
- What the ratio signifies
The significance of the accounts receivable turnover ratio for businesses can be described in different ways, such as:
- It indicates how many times a business can turn its receivables into cash, indicating the liquidity of the accounts receivable.
- It determines how successfully a firm collects money owed by debtors.
- It refers to the number of times per accounting period (such as a year) that a business turns its accounts receivable over.
A high turnover ratio can be a combination of conservative payment terms (credit policy), a well-organised debt collecting process, as well as a number of trustworthy customers.
Conversely, a low turnover ratio may be caused by an open-minded or non-existent credit policy, an inability to collect outstanding debt, and or numerous customers who experience financial problems.
In addition, it is quite possible that a low turnover ratio is an indication of a significant amount of bad debt.
- Similar term
The accounts receivable turnover ratio is also referred to as the debtor’s ratio.
- Formula
Accounts receivable turnover ratio = Net credit sales/Average accounts receivable
Net credit sales exclude all-cash sales.
To calculate the average accounts receivable, the opening and closing balances of accounts receivable for a specific accounting period, such as a year, are added together and divided by two.
- Example
Let us say company ATZ sold goods on credit to the amount of R2 000 000 during the past financial year. Its asset account of receivables had an opening balance of R300 000 and a closing balance of R320 000, respectively.
ATZ’s accounts receivable turnover ratio is calculated as follows:
Average accounts receivable = R310 000 ((R300 000 + R320 000)/2)
Turnover ratio = R2 000 000/R310 000
= 6.45 %.
The result indicates that the balance of ATZ’s accounts receivable turned over almost 6.5 times during its financial year. Typically, a ratio under 10 is an indication of an inadequate credit policy and a deficient collection process.
Average collection period ratio or average collection period in days
- What the ratio signifies
The average collection period ratio, also called the average collection period in days, is closely related to the accounts receivable turnover ratio, indicating how effectively a firm can collect debt from debtors and what the average duration is to collect the debt.
Furthermore, this ratio shows how effectively a company executes its credit policy and to whom it extends credit. Typically, the average collection period should not exceed the company’s credit terms.
The average collection period is a useful tool when utilised to compare one business with its competitors, either individually or as a group. For example, the average collection period can be used as a benchmark in a specific industry.
- Formulas
The average collection period ratio, and the average collection period in days, are calculated by using two different formulas:
- Formula 1
Average collection period ratio = Average accounts receivable/Average credit sales per day
- Example 1
The information of company ATZ is also used in the following two examples.
Company ATZ’s average collection period ratio will look as follows:
(R310 000/R2 000 000) x 365
= 56.58 days.
If ATZ’s credit terms are 30 days, almost 57 days is not a good figure. However, if the company’s credit terms are 60 days, the collection period ratio is within the terms that have been stipulated.
- Formula 2
Average collection period in days = 365 days/Accounts receivable turnover
- Example 2
365 days/6.45
= 56.59 days.
- Similar terms
The average collection period in days is also referred to as days sales outstanding (DSO).
Accounts payable
Accounts payable, also known as payables, refer to money owed by a business to its suppliers, referred to as creditors, for goods or services bought on credit.
Accounts payable turnover ratio
- What the ratio shows
The payables turnover ratio measures how quickly a business is paying off its suppliers.
When the turnover ratio declines from one accounting period to the next, it is a signal that a business is paying its creditors more slowly, which may be an indication of a deteriorating financial condition. This could make a business more of a credit risk, making it difficult to negotiate for favourable credit terms.
Contrarily, the higher the accounts payable turnover ratio, the more favourably suppliers consider a business, allowing the business favourable credit terms. The turnover ratio can be improved by negotiating longer credit terms with creditors.
- Similar terms
The accounts payable turnover ratio is also known as the payables turnover ratio or the creditor’s turnover ratio.
- Formula
Accounts payable turnover ratio = Total purchases/Average accounts payable
Total purchases exclude any cash purchases.
Concerning average accounts payable, the amount is calculated by adding the opening and closing balances of the accounts payable together and dividing the sum by two.
- Example
Company MRM’s financial records reflect accounts payable with an opening balance of R750 000 and a closing balance of R790 000. Purchases from suppliers for the past financial year were R7 000 000.
Company MRM’s accounts payable turnover will be calculated as follows:
Average accounts payable = R770 000 ((R750 000 + R790 000)/2)
Accounts payable turnover ratio = R7 000 000/R770 000
= 9.09 times
The result indicates that company MRM’s payables turned over approximately 9 times during the past financial year.
Days of payables outstanding (DPO)
- What DPO shows
Another way to determine how efficient a company’s management of its creditors is, is to measure the number of days it takes to pay off creditors. Express differently, DPO shows the average number of days that a payable remains unpaid.
- Formula
365 days/Accounts payable turnover ratio
- Example
Company MRM’s information as above, is used in this example.
365 days/9.09 times
= 40.15 days
The result shows that company MRM takes about 40 days to pay off its creditors.
Fixed assets
Fixed assets, also called non-current assets, refer to long-term tangible assets that are used by a business in its operations to generate revenue.
Fixed assets have the following features:
- They have an expected useful life that exceeds one year
Fixed assets are not expected to be consumed within a year.
- They can be depreciated
Fixed assets are depreciated on a yearly basis, reflecting the wear and tear of using the asset. The exception is land which is not subjected to depreciation.
- They are used in business operations and allow long-term financial gain
Businesses use fixed assets to produce goods and provide services in order to generate revenue. They are kept in a business and are not sold or held for investment purposes.
- They are illiquid
Fixed assets cannot easily and quickly be converted into cash.
Examples of fixed assets are plant & machinery, vehicles, land, and office furniture.
Fixed asset turnover ratio
- What the ratio indicates
The fixed asset turnover ratio measures a company’s ability to generate sales from its investment in fixed assets. Simply put, the turnover ratio compares net sales to net fixed assets.
A high turnover ratio indicates, among others, the following facts:
- A business is generating sales with a relatively small amount invested in fixed assets.
- Some business operations are outsourced, avoiding over-investing in fixed assets.
- Excess fixed assets are sold.
The more efficient the management of fixed assets, the higher the ratio.
A low ratio shows, inter alia, that a business:
- Needs to issue new products to revitalise its sales.
- Has over-invested in fixed assets.
- Formula
Fixed asset turnover ratio = Net sales/ (Fixed assets – Accumulated depreciation)
Net sales are the gross sales of a business, excluding returns, discounts, and allowances.
Concerning fixed assets, intangible assets are not included. If the amount of fixed assets varies considerably over time, determining an average fixed asset figure may be necessary.
- Example
Company Happy Days has fixed assets of R4 500 000 and accumulated depreciation of R1 800 000. Its sales for the past financial year were R8 000 000.
The calculation of company Happy Days’ fixed asset turnover ratio is:
R8 000 000/ (R4 500 000 – R1 800 000)
= R8 000 000/R2 700 000
= 2.96 Turnover per year
The result of 2.96 above means that company Happy Days generated R2.96 of sales for every rand (R1) invested in fixed assets.
Total assets
Total assets refer to all the assets reported on a firm’s balance sheet, comprising fixed assets, current assets, intangible assets, and long-term investments.
Total assets turnover ratio
- What the ratio measures
The total assets turnover ratio measures how efficiently a business is utilising its total assets to generate sales during a certain accounting period.
Generally, a high ratio signals that a business is utilising its total assets efficiently to generate revenue, or that it does not have many assets.
On the contrary, a low ratio shows that too much money is invested in assets or that the total assets are not being used proficiently in generating income.
The ratio can vary from industry to industry. Hence, a business will compare its ratio with businesses of similar size in the same industry.
- Formula
Total assets turnover ratio = Net sales/Average total assets
As with the fixed asset ratio, net sales are the gross sales of a business minus discounts, allowances, and returns.
Regarding average total assets, all the assets (fixed, current, intangible) of a company are included. The average total assets are calculated by adding the opening and closing balances of all the assets together and dividing the sum by two.
- Example
Company Peace & Prosperity reported net sales of R273 000 for the past financial year. The total of all the opening balances of all the assets was R75 000 and the total of the closing balances R83 000.
Peace & Prosperity’s total assets turnover ratio is calculated as follows:
Average total assets = R79 000 ((R75 000 + R83 000)/2)
Turnover ratio = R273 000/R79 000
= 3.46 %
The above result indicates that company Peace & Prosperity currently generates R3.46 in sales for each rand of total assets.
[1] See the article, ‘Accounting Explained for Dummies’, for more information about accounting in general.
[2] Refer to the article, ‘Assets Explained for Dummies’, for a detailed explanation of assets.
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