When understanding the financial performance of a business entity, simply analyzing its capacity to generate profits is not sufficient.
A company might be very profitable. But it is important to know what is the maximum amount of profit that it is able to make for the owners as well as the shareholders with the help of available resources with the company.
In other words, it is important to know how efficiently and effectively a business entity is able to utilize and manage its assets. And get the maximum out of them in terms of sales and profit.
If the business entity invests excessive amount in its assets, this would mean that the company has parked excessive funds in the form of working capital. Similarly, if the business entity invests less amount of funds in assets, it will lose out on sales that will further hamper its profitability and cash flows.
Thus, business owners need to make a decision with regards to the amount of funds to be invested in various assets of the business.
They can either consider the amount invested in various assets by them over the years to see the optimal amount to be invested for maximum profitability. Or else, they can compare the amount invested by various competitors in their industry in various assets and come up with a best estimate for the same.
How Activity Ratios Help A Business?
This is where Activity Ratios help business owners in understanding how well they have been utilizing or managing their assets and generating profits out of them.
For instance, the industry norm for collecting money from debtors is 45 days. However, your business has been allowing a credit period of 60 days. Due to this relaxed credit period policy adopted by the business, it is not able to undertake its day to day operations effectively.
What Are Activity Ratios?
Activity Ratios, also known as ‘Turnover Ratios’ or ‘Efficiency Ratios’, measure a business entity’s ability to utilize its assets and manage its liabilities.
In other words, Activity Ratios are the indicators of the operating performance of a business entity. That is, its capacity to convert assets into sales.
Activity Ratios express how well the business entity is able to manage its working capital as well as long term assets.
Since these ratios express the efficiency of a business and its management, some of these ratios also help in analyzing the liquidity position of the business entity. That is, the ability of the company to meet its short term obligations.
Thus, there are various types of activity ratios that help to measure the efficiency of a business entity.
Types of Activity Ratios
1. Inventory Turnover Ratio
Inventory Turnover Ratio measures the effectiveness with which a business entity manage its inventory.
It indicates the number of times inventory gets converted into revenue from the operations of a business entity during a given accounting period. The formula for inventory turnover is:
Inventory Turnover (in times) = (Cost of Sales) or (Cost of Goods Sold)/Average Inventory
Days of Inventory on Hand (in Days) = 365/Inventory Turnover
Average Inventory = Average of Opening and Closing Inventory = (Opening Inventory + Closing Inventory)/2
Cost of Goods Sold = Revenue from Operations – Gross Profit
Thus, Inventory Turnover Ratio measures the pace at which finished goods gets converted into revenue. In other words, it indicates the number of times inventory is purchased during the year.
Lower Inventory Turnover ratio compared to the industry standard would be an indicator of slow moving inventory due to obsolescence, change in the industry trends.
On the other hand, higher Inventory Turnover Ratio could either be due to effective inventory management or less inventory at hand that could be an indicator of future shortages to the business entity.
2. Trade Receivable Turnover Ratio
This ratio indicates the pace at which the company or a business entity is able to realize payments from its debtors. In other words, it indicates the time period for which a business entity allows credit to its customers.
Thus, the formula for Trade Receivable Ratio is:
Trade Receivables = Net Credit Revenue/Average Receivables
Debt Collection Period (in days) = 365/Receivables Turnover
Net Credit Revenue = Total Revenue – Cash Revenue from Operations
Average Trade Receivables = (Opening Debtors + Closing Debtors)/2
Debt Collection Period is nothing but the time period between sales and the amount received for such sales
A higher Receivables Turnover Ratio could be an indicator of effective credit and collection policy of the business entity. However, it could also mean strict credit and collection policy adopted by the business entity which might result in losing business to competitors.
On the other hand, a low Receivables Turnover Ratio could mean ineffective receivables management on the part of the business entity.
3. Trade Payables Turnover Ratio
Payable Turnover Ratio measures the number of times a business entity pays to all its creditors in a given accounting period. Credit Payment Period on the other hand is the average number of days a business entity takes to pay its suppliers.
The formula for Trade Payables Turnover Ratio is as follows:
Trade Payables Turnover = Net Credit Purchases/Average Creditors (or Average Trade Payables)
Net Credit Purchases = Total Purchases – Cash Purchases
Average Creditors = (Opening Creditors + Closing Creditors)/2
Average Payment Period = 365/ Trade Payables Turnover
A lower Trade Payables Ratio indicates that the business entity is allowed a longer credit period by its suppliers. Alternatively, it could also mean delayed payments on the part of the business entity to its suppliers. Such a payment policy is not in favor of business entity as it would certainly impact its reputation in the market.
Whereas, a higher Trade Payables Turnover as compared to the industry norm would mean that the business entity is not making full use of the credit facilities made available to it. Alternatively, it could also mean that the company is availing discounts for early payment.
4. Investment (Net Assets/Total Assets) Turnover Ratio
This ratio indicates the overall ability of the business entity to generate revenues with the given amount of assets.
Thus, the formula for Total Assets Turnover Ratio is:
Total Assets Turnover = Revenue/Average Total Assets
A Total Assets Turnover Ratio of 0.2 indicates that the business entity is able to generate Rs 2 in terms of revenue for every Re 1 invested in its total assets.
Such a ratio helps in determining both the efficiency of the business entity as well as the strategic decisions undertaken by the management. For instance, whether to go for a less capital intensive approach to undertake its business or a more capital intensive approach towards it.
5. Fixed Assets Turnover Ratio
Fixed Assets Turnover Ratio indicates the efficiency with which a business entity is able to generate revenues from the amount of investments made in fixed assets.
The formula for Fixed Assets Turnover Ratio is:
Fixed Assets Turnover = Revenue/Average Net Fixed Assets
Higher Fixed Assets Turnover Ratio is an indicator of efficiency on the part of the business entity in utilizing its fixed assets to generate sales. Whereas, a lower Fixed Assets Turnover Ratio indicates inefficiency, capital intensive business environment or a new business that is not operating at its full capacity.
6. Working Capital Turnover Ratio
Working Capital = Current Assets – Current Liabilities
Thus, Working Capital Turnover Ratio is nothing but the revenue generated from the business operations and the capital employed to undertake the same.
In other words, this indicates the efficiency with which business entity is able to generate sales or revenue with the amount of working capital available with it.
The formula for Working Capital Turnover is:
Working Capital Turnover = Revenue from Operations/Capital Employed
For instance, Working Capital Turnover Ratio of 3.0 indicates that the business entity is able to make Rs 3 in sales with every Re 1 invested in the form of working capital.
Thus, higher Working Capital Turnover ratio reflects increased efficiency on the part of the business entity. That is the entity is able to make greater sales as compared to the working capital invested by such an entity.