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.
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.