Companies generate sales revenue by using their operating assets. Some companies can be more efficient than others in their business activities, quantified using the activity ratios formula.
Activity ratios are interpreted depending on whether a ratio is high or low. A high activity ratio indicates that a company uses its operating assets efficiently. On the other hand, a low activity ratio indicates that a company is not using its operating assets optimally.
Activity Ratios Formula
1. Accounts Receivables Turnover Ratio Formula
In the daily operations of a company, there are those customers who request credit facilities. These credit facilities are extended to such customers with an agreement to repay within a stipulated time. A company must ensure it collects these credits extended within a reasonable time.
The number of times a company collects account receivables per year is the accounts receivables turnover ratio.
To protect a company’s financial health, a high accounts receivables turnover ratio is desired. A company with high accounts receivables turnover ratio does not necessarily extend credit facilities at ease, and when it does, it is always strict on its repayment. The higher the accounts receivables ratio, the better.
A company with an accounts receivables turnover ratio of 8.5 means it collects its accounts receivables more than eight times in a given financial period.
The accounts receivables turnover ratio is calculated by dividing net credit sales by the average of accounts receivables.
|Accounts Receivables Turnover Ratio = Net Credit Sales ÷ Average Accounts Receivables|
2. Assets Turnover Ratio Formula
Assets are there to help a company generate sales. Some companies are more efficient in asset utilization than others. A good assets turnover ratio is anything above one.
However, this is subject to the industry’s average asset turnover ratio. Suppose the asset turnover ratio of a company is 1.5 and that of the industry is 2. In that case, such a company still performs poorly utilizing assets to generate sales revenue.
A company with an assets turnover ratio of 2.7 generated $2.7 from sales proceeds from each $1 of assets.
The formula for the assets turnover ratio is net sales divided by average assets.
|Assets Turnover Ratio = Net Sales ÷ Average Total Assets|
3. Working Capital Ratio Formula
Current assets and current liabilities finance daily business operations. The working capital ratio is derived from these two balance sheet items. A good working capital ratio should be between 1 and 2.
However, the ratio of a company is only declared ideal after it has compared with the industry’s average.
Investors and companies use the working capital ratio to assess how financially stable a company is in the short run. A company with a reasonably low working capital ratio (between 1 and 2) utilizes its current assets efficiently. A company with an extremely high working capital ratio (more than 2) has more of its assets idle and underutilized.
One company has a working capital ratio of 1.3, and another has 2.3. A company with a 1.3 working capital ratio is more efficient in asset utilization than a 2.3 working capital ratio.
The formula for the working capital ratio is current assets divided by current liabilities.
|Working Capital Ratio = Current Assets ÷ Current Liabilities|
4. Inventory Turnover Ratio Formula
Some companies sell their inventory faster than others. This could be due to the nature of products sold, market size, or even demand and supply forces changes.
The number of times a company has sold and restocked its inventory is referred to as inventory turnover. The higher the inventory turnover ratio, the better. This turnover ratio is compared to the industry average to avoid misinterpreting a high turnover ratio below the industry average as an ideal ratio.
Suppose an industry’s average inventory turnover ratio is 9. In that case, a company with an inventory turnover ratio of 7 is better, but it’s performing poorly compared to an entire industry.
In another scenario, a company could have the same inventory turnover ratio of 7, but the industry’s ratio is 5. Such a company is operating better than most of its competitors in its industry.
To calculate the inventory turnover ratio, divide the cost of goods sold by the average inventory.
|Inventory Turnover Ratio = COGS ÷ Average Inventory|
5. Fixed Assets Turnover Ratio Formula
The efficiency of a company in using its fixed assets and generating sales revenue is measured using the fixed assets turnover ratio. An ideal fixed assets turnover ratio differs from one company to another depending on the industry of operation.
Companies desire a higher fixed assets turnover ratio as it indicates efficient utilization of fixed assets.
To calculate the fixed assets turnover ratio, divide the net sales by the average fixed assets.
|Fixed Assets Turnover Ratio = Net Sales ÷ Average Fixed Assets|
6. Days Payable Outstanding Formula
Just like in the collection of debts, a company is a debtor to its creditors. In the same way, companies emphasize a collection of credit facilities extended, and their creditors also push them to pay debts as they fall due. The average days a company takes to pay its creditors is called days payable outstanding.
The higher the days payable outstanding, the more critical the warning is. This implies that a company cannot pay its liabilities as soon as they fall due.
If the days payable outstanding of a company is 11, it means that a company takes an average of 11 days to settle liabilities once they fall due for payment.
To calculate days payable outstanding, take accounts payable, divide by cost of goods sold, and multiply the resultant figure by the number of days in the accounting period in question.
|Days Payable Outstanding = Accounts Payable ÷ COGS × No. of Days in Accounting Period|