What is the Activity Ratio formula?
The term “activity ratio” refers to a set of financial metrics that can be used to assess whether a company’s management can successfully use its assets to generate operational cash. In other words, these ratios demonstrate how well the company’s management converts its assets into cash.
The following points can be used to calculate the Activity Ratio Formula:
1. Accounts Receivable Turnover
This ratio represents a company’s credit policy and, as a result, assesses its capacity to collect accounts receivable generated by credit sales. A higher score often indicates that the organisation can collect receivables quickly, assuming good credit practises, and vice versa.
Another name for the ratio is debt turnover ratio. The accounts receivable turnover ratio is calculated by dividing the relevant company’s revenue by its average accounts receivable. It is written mathematically as,
Accounts Payable Revenue / Average Accounts Receivable = Turnover Ratio
2. Merchandise Inventory Turnover Ratio
This ratio measures how well a company transforms its stock and work-in-process (WIP) inventory into cash. A higher value typically suggests that the company can quickly sell its inventory to generate sales, and vice versa.
The ratio is also known as a stock turnover ratio. The merchandise inventory turnover ratio is calculated by dividing the cost of sales by the average inventory. It is written mathematically as,
Cost of Sales / Average Inventories = Merchandise Inventory Turnover Ratio
3. Asset Turnover Ratio Total
This ratio assesses a company’s ability to generate sales by leveraging both long-term and short-term assets. A higher value typically means that the company can generate more sales by exploiting its assets, which is excellent. The total asset turnover ratio is computed by dividing revenue by the average total asset value for a certain time period.
It is written mathematically as,
Total Asset Turnover Ratio = Revenue / Average Asset Turnover Assets in total
4. Net Fixed Asset Turnover Ratio
This ratio illustrates a company’s ability to generate sales through the use of fixed assets such as plant, property, and machinery. A higher score typically indicates that the organisation makes effective use of its fixed assets.
The net fixed asset turnover ratio is derived by dividing revenue by the period’s average net fixed asset value. It is written mathematically as,
Net Fixed Asset Turnover Ratio = Revenue / Average Fixed Asset Turnover Fixed Assets Net
Activity Ratios vs. Profitability Ratios
Both activity and profitability ratios should be studied to assess a company’s financial health.
Gross margin and operational margin are profitability measures that demonstrate a company’s complete ability to convert revenues into earnings after deducting various costs and expenses.
Activity ratios, on the other hand, demonstrate a company’s ability to efficiently use its resources (i.e. assets) to generate profits at a finer level (i.e. per asset).
Inventory, Receivables, and Payables Turnover Ratio
The higher the turnover ratio, the better, as it suggests that the company can generate more revenue while using fewer assets.
Because most organisations monitor their accounts receivable (A/R) and inventory movements, these accounts are commonly used as the denominator in activity ratios.
While there are many other types of activity ratios, such as the accounts receivable turnover ratio and inventory turnover ratio, they all have the same goal: to determine how efficiently a company can utilise its operational assets.
Better activity ratios are connected with higher profit margins because more value is extracted from each asset.
Some of the more common ratios are as follows:
Inventory turnover is the number of times a company’s inventory is replaced in a given period.
Receivables Turnover Ratio — The number of times a typical client who previously paid on credit (i.e. accounts receivable, or “A/R”) makes a cash payment in a particular period.
Payables The turnover ratio is the number of times a corporation pays its due payments to suppliers/vendors (i.e. accounts payable, or “A/P”) in a given period.
Other Activity Ratio Formulas
Integrate Activity Ratios Into Your Company
If you use activity ratios appropriately, they can provide you with information about anything. It makes no difference how quickly you move stuff or how quickly you pay your vendors.
They can also provide useful business statistics, indicating whether or not your firm is doing well and supporting you in recognising potential problems.
If you notice that your accounts receivable turnover ratio is insufficient, changing your credit conditions and determining who is eligible for credit may help you boost the ratio.
You must use your company’s activity ratios on a regular basis if you choose to do so. A single ratio will tell you very little about your company’s performance. Maintaining these ratios, on the other hand, allows you to see patterns and tackle potential problems. As you analyse your ratios, compare them to those of similar businesses in the same industry.
Making money in your business is difficult. Having the right tools to promote development and earnings can go a long way toward assuring your company’s long-term viability. This job can be made more manageable by employing approaches such as activity ratios.
The Limitations and Drawbacks of Activity Ratios
While activity ratios can be a useful tool for reporting financial ratios, they only provide a tiny portion of the information required to determine how well your company is currently performing.
Like other accounting terminology, activities ratios are largely concerned with previous occurrences. This can provide information on how your company has done up to that time. This data, however, cannot be used to anticipate your company’s future success.
Furthermore, like any other accounting ratio, activity ratios provide useful information but cannot address any current financial problems. When used out of context, the data they present can be misleading.
Finally, they will be impacted if your financial statements and ratios are wrong. As a result, start with the most recent financial statements.