The efficiency of any business can be assessed by its activities. These activities are reflected through the liquidity of the firm. Liquidity is the ability of the firm to convert its investment in different assets like inventory, receivables and liability into cash. Evaluation of activity ratio determine whether the management is generating right revenues out of resources. These ratios are also known as efficiency ratios, turnover ratios or operating ratios. These ratios use the elements of income statement and balance sheet.
Need for Activity Ratios
Any business is required to determine its efficiency either to compare with its past year performance or more importantly to compare with industry- averages in order to compare your performance and efficiency with that of competitors. Company uses these ratios to determine the efficient usage of its assets.
These ratios are used by companies to determine operating cycle and credit policy of firm. operating cycle is the time period between acquisition of goods and cash realization. It is calculated by adding collection period and holding period. It is also used to set credit policy of the firm that is days required to pay suppliers and days required to receive from customers.
Inventories and account receivable are two critical assets of the firm and influence the profitability and liquidity of the firm. sales and cost of goods sold generate the accounts of receivable, inventory and payables. the buying and selling of the firm indicates the activity of the firm. Their ratio analysis provides their ability of generating revenue. There are many types of activity ratios like Inventory turnover ratio, Account receivable turnover ratio, Total asset turnover etc.
Account receivable Turnover
This ratio determines the liquidity of the account receivable. It shows how quickly the receivables are collected into cash. It measures the number of times per year receivables are collected. It is given by formula
Account receivable turnover = Net sales / average gross receivables
Receivable turnover plays a major role in determining the credit policy of the firm. High turnover shows that firm aggressively collects from its customer. Account receivable turnover determines the average collection period. ACP is the number of days after which receivables are collected. A high turnover means short period of collection. This means that firm has a good sales position and have good quality of customers. Whereas a low turnover ratio shows whether the company has weak credit policy, customers with financial difficulties, relatively a large amount of bad debts. Average collection period is given by the formula.
ACP = (1/ account receivable turn over)* 365
Inventory turnover determines the liquidity of inventory. The ratio shows the efficiency in managing the inventory. Inventory turnover is affected by two factors: the purchasing of inventory and sales of inventory. Higher turnover value indicates lower amount of inventory whereas lower turnover indicates higher amount of inventory and high holding period. There are two costs associated with the company are carrying cost and ordering cost. Higher amount of inventory leads to low ordering cost but higher carrying cost where as low inventory would result in higher ordering cost and low carrying cost. In order to consider the right amount of inventory these costs should be considered. Sales have to be increased and matched to the amount purchased in order to increase the inventory turnover. Inventory turnover is given by:
Inventory turnover = cost of goods sold / average inventory
This can also be expressed in days of holding the inventory known as holding period and is given by:
Inventory turnover in days = (1/ inventory turnover) * 365
Account Payable Turnover
This is an another measure that analysis the efficiency of firm by evaluating the number of times company pay debt to its suppliers. Higher turnover ratio indicates the ability to pay its suppliers quickly and frequently and vice versa. This can also be expressed in days taken by firm to pay its suppliers by days payable outstanding. The formula if payable turnover is given by
Account payable turnover = C.G.S / account payable
Days Payable outstanding = ( account payable/ C.G.S)* 365
There are many more such ratios like total asset turnover ratio, working capital turnover ratio which measure the contribution of assets in generating revenue.
Fundamental of financial management by Van Hon
Financial Reporting and Analysis by Charles H Gibson