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What is an Activity Ratio?

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  • Written By: K.M. Doyle
  • Edited By: W. Everett
  • Last Modified Date: 11 September 2016
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An activity ratio is one of several accounting ratios that measure how quickly a company can convert certain of its assets into cash, or revenue. Three commonly assessed activity ratios are the asset turnover ratio, the inventory turnover ratio and the receivables turnover ratio. An activity ratio, along with other accounting ratios, is used in fundamental analysis to determine the relative strength of a company compared to its competitors. The information used to calculate an activity ratio is found on a company’s balance sheet or income statement.

The asset turnover ratio indicates how quickly, on average, a company can turn an asset into cash. The asset turnover ratio is calculated by dividing sales by average total assets. If annual sales are $1 million U.S. dollars (USD) and the average assets throughout the year are $500,000 USD, the asset turnover ratio is 2. This means that the company turns over its assets twice a year. A higher asset turnover ratio is better, because it means the company turns over its assets more frequently, so it is more quickly converting assets into sales.

The inventory turnover ratio indicates how often the company turns its inventory into revenue. Again, a higher ratio is better because it indicates that the company is moving product quickly from its warehouse into stores and, ultimately, into the consumers’ hands. Analysts can determine the inventory turnover ratio by dividing sales by average inventory.

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A company’s efficiency in collecting the money owed by customers is measured by the receivables turnover ratio, sometimes called the accounts receivable turnover ratio. To determine the this ratio analysts divide net credit sales by average accounts receivable. A low ratio can mean that the company has trouble collecting from its customers. A company that does most or all of its business on a cash basis will have a very high receivable turnover ratio.

As with all accounting ratios that are used in fundamental analysis, it is important to compare any activity ratio between companies within the same industry. Some industries will typically have far lower ratios than others, so comparing companies across industries will usually produce irrelevant data. For example, an activity ratio for a manufacturing company will typically be far lower than the same activity ratio for a fast food company. In order for the comparison of an activity ratio between two or more companies to be useful, the companies should be in the same industry.

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omgnotagain
Post 4

@kangaBurg – I sell stuff online too. My business is three years old, and activity ratio analysis helped me find a few things I needed to fix when it came to handling my business’ finances.

For example, my business does decent sales, but my asset turnover ratio was really low. I didn’t realize I had an entire category of items that simply weren’t selling. I looked back at my inventory records and saw that about a quarter of my assets were just sitting in my storage room.

I did a massive clearance sale and finally sold those items. I made about 25 cents per product, which is better than nothing, and now I have more room for stuff that

will actually sell.

I had an accounts receivable turnover problem too. Because I’m a nice person, I would send layaway orders to my customers after they had paid half of the total order price.

After receiving the order, half of my customers forgot to continue paying off the layaway loans. I’m not very organized, so I didn’t notice. I took care of it after the problem was revealed, and have collected almost all of the past due layaway payments.

From my experience, I think even a small business like yours can benefit from activity ratio analysis, so try it out!

kangaBurg
Post 3

I run a small online business, selling handmade jewelry. Is activity ratio analysis something I need to do, or will a simple profit and loss sheet be good enough? I only do about $2,000 in sales each month.

Frances2
Post 2

@parklinkz – That’s a good question. It seems like every company would demand payment as soon as they finish working for a client, doesn’t it? Well, I have quite a few friends who work in industries where it’s common practice to wait weeks - or even months – before collecting payment from a client.

I was surprised to hear that radio advertising spots are often paid for months after the ad campaign has finished running. My childhood friend is an advertising sales representative for a local broadcasting company, and they’ve had a hard time collecting money from advertisers for the past two years.

Manufacturers and distributors of products can have problems, too. Another friend of mine is a bookkeeper for a

company that distributes goods to retail stores. They bill their customer on a Net 30 basis, which means the retail store has 30 days to pay for the goods, after receiving them.

I’m a freelance web designer, and when I work with a new client, they have them put my fee into an escrow account. That’s an account that holds the money until I have completed my work. Then, the client releases the money to me. Using escrow has cut down on non-paying clients. I think it scares away the scam artists.

parklinkz
Post 1

The article says that if a company has a low receivables turnover ratio, it means the company has trouble collecting money from its customers, but how is that possible? How does a company end up not collecting the money it’s due, and how can a company get out of that kind of situation?

I’m sure loan companies have a problem with this often, so I would like to know how firms in other industries end up in that situation.

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