If we start with the activity ratio definition, then activity ratios are financial measures that evaluate how effectively a business uses its assets. The most important efficiency ratios are the total turnover rate of assets, inventory turnover ratio, work-capital turnover rate and accounts receivables ratios.
Also, it includes days of sales that remain outstanding during the operating cycle, the number of days of inventory not used and so on. Analysing how long cash remains in different assets like receivables and inventories is crucial because these assets do not yield any revenue. Instead, they incur costs, such as the carrying cost in the case of inventories.
It is crucial to swiftly dispose of inventory and get the cash from receivables so that you can use them to make more sales. The key to a high return for shareholders is to create more revenue and thus higher income for investors by using their money more efficiently.
Did you know?
There are six activity ratios, each having a different formula and importance. Many of the biggest companies in the world follow these activity ratios to streamline their businesses and ensure perfect functioning.
Also Read: A Guide on How to Maintain Accounts With or Without Inventory in Tally ERP 9
What Is the Activity Ratio Meaning?
Just knowing the activity ratio's meaning isn't enough, and it's worth checking the advantages as well. There are a variety of advantages to using activity ratios. They are easy to identify what parts of the financial statement need a more thorough examination, and it can narrow the focus of management.
Additionally, you can use them to compare a company's performance against that of competitors and show management areas where the company can make changes. Finally, investors can use these ratios to assess whether a company is efficiently run to warrant the value of their investment.
Use Activity Ratios in Your Company
If you use it correctly, activity ratios can provide you with information about everything. Be it the speed you're moving inventory around to how quickly you're making payments to your vendors.
They can also provide useful statistics for your business, revealing that your business is doing well and helping you find areas of concern.
If, for instance, you notice that your turnover of accounts receivable ratio is not sufficient, doing things like revising your credit conditions and who's qualified for credit could help in increasing the ratio.
If you decide to use the activity ratios of your company, it is essential to do it regularly. A single ratio will reveal little information about your business's performance. However, keeping these ratios in check allows you to see patterns and address developing issues. While analysing your ratios, evaluate them against similar businesses in the same sector.
Making money in your business isn't easy. Having the right tools to boost growth and increase profits can go a long way to ensure that your business is viable in the short term and over a long time. Using tools such as activity ratios can make this job more manageable.
Limitations and Negatives of Activity Ratios
While they can be a helpful tool to report on financial ratios, activity ratios can only provide just a small portion of the information that you require to determine how well your company is in the present.
Similar to other accounting measures, activities ratios generally focus on historical activities. This can provide information on how your company has been doing up to a certain level. However, you can't depend upon this info to predict the future performance of your business.
Furthermore, like any other accounting ratio, activity ratios offer important information but cannot address any current financial problems. If used outside of context, the data they offer can be misleading.
In the end, if your financial statements and ratios are not accurate, they are also affected. Therefore, you must start with the most accurate financial statements.
What Are Activity Ratio Types?
There's a vast array of ratios for the activity that business owners can calculate, and we've chosen the most vital ratios. We'll explain why you can use each ratio to calculate the formula the ratio. Most companies calculate activities ratios every year, but you may also do them more often when you'd like. You can retrieve the figures used to calculate these ratios through your financial statements or balance sheets. Once you join a job or start your own, the communication skills will matter a lot, so be sure to master them.
1). A Turnover Ratio of Accounts Receivable
Similar to the accounts payable turnover, the accounts receivable to turnover ratio measures how quickly your clients pay their credit accounts.
To determine this ratio, you'll have to gather your sales figures for credit for the specific period. Further, you'll have to ensure that you subtract any cash sales and other unrelated revenues from the total sales. Also, you'll need to determine your average accounts receivable balance.
Net credit sales/average accounts receivable = accounts payable ratio of turnover
2). The Turnover Ratio of Accounts Payable
The accounts payable turnover rate offers a great idea of how fast your business can pay off the debts, considering the days between supplier and vendor purchases and when you made the payment.
Various dates used for this calculation could differ depending on how often the rate is determined. If you calculate the accounts payable ratio to turnover quarterly, the required days are 90, and a whole year has 365 days.
It is necessary to know the total amount of purchases your business makes using credit when you're formulating this ratio. If you're looking to calculate the turnover ratio in accounts payable for the entire year, you'll need the total value of your credit purchases during the whole year.
In the next step, you'll have to prepare an account balance sheet at the start and closing of the year. To determine the beginning and end of your accounts balances that are payable, you'll have to find the average.
The formula to calculate the ratio of accounts payable to turnover is as the following:
Total Purchases / Average Accounts Payable = Accounts Payable Turnover Ratio
Also Read: What is Inventory Management Software System?
3). The Ratio of Fixed Asset Turnover
The ratio of fixed asset turnover determines the capacity of your company to earn revenue through fixed assets.
To calculate such a ratio, you'll first need to determine the average fixed assets amount. You can obtain it from a starting and ending balance sheet for the time you've considered.
Then, you'll get the net sales total. Include cash and credit sales and subtract any allowances/returns into your calculation.
Net Sales / Average Fixed Assets = Fixed Asset Turnover Ratio.
4). Average Collection Period Ratio
If you're looking to know the exact length of time, it takes to get your accounts receivable balances. Also, an average collection ratio can be useful. The accounts receivable turnover ratio provides a summary of collection activity. But it cannot give the exact information of what the standard collection ratio does.
If you're using this ratio for a year, we'd recommend including all 365 days of the year. It is also necessary to calculate your average balance in accounts receivable similar to the ratio of turnover for accounts receivable and net credit sales you calculated by examining your balance sheet.
Days in period x Average Accounts Receivable / Net Sales = Average Collection Period Ratio
5). The Ratio of Total Asset Turnover
Like the fixed ratio of turnover of assets, the ratio of total turnover calculates all company assets, and it evaluates your company's capacity to use its assets to drive sales.
The formula is designed to be calculated by year-end at the end of the year. The total turnover ratio results may vary significantly from industry to industry. When comparing your results, ensure to compare them with similar businesses.
Net Sales / Average Total Assets = Total Asset Turnover Ratio
6). The Ratio of Inventory Turnover
If you are a retailer in your company, understanding the turnover rate is crucial, and it's a measurement that determines the efficiency of your inventory management practices.
To calculate the turnover rate, you'll require two sets of figures:
- The cost of the goods you sold during the period you're formulating your ratio.
- Your average inventory values for that same time frame.
We can derive the average inventory amount from both the balance sheets for the beginning and end of the period you've considered, and you can list the cost of selling goods in your earnings statement.
Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio
7). The Ratio of Working Capital
The last activity ratio we'll be looking at is working capital. This operating capital ratio measures how efficiently your company is using its working capital.
Net Sales / Working Capital = Working Capital Ratio
Conclusion
The activity ratio analysis is used to assess the company's efficiency in capital utilisation. Activity ratios tell us how well a company controls its inventory of cash, cash payables, receivables and other assets.
We suggest you plot the ratios of activity for the business on an upward trend line. It will determine if there are any longer-term trends in the way you can handle them.
Successful businesses exhibit a continuous, steady increase in these ratios as management seeks new ways to increase their business capacities. Most importantly, you should easily automate all payments online to handle debit and credit transactions through Khatabook easily.
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