What is the formula for the Activity Ratio?
The phrase “activity ratio” refers to a set of financial measurements that can be used to determine whether a company’s management can effectively use its assets to create operational cash. To put it another way, these ratios show how well the company’s management converts its assets into cash.
Explanation
The following are the points that can be used to compute the Activity Ratio Formula:
1. Turnover of Accounts Receivables
This ratio reflects a company’s credit policy and, as a result, gauges its ability to collect accounts receivable created as a result of credit sales. A higher score typically suggests that the organisation is able to collect receivables promptly, implying excellent credit practises, and vice versa. The debt turnover ratio is another name for the ratio.
The formula for calculating the accounts receivable turnover ratio is to divide the subject company’s revenue by its average accounts receivable. It is expressed mathematically as,
Accounts Receivable Turnover Ratio = Revenue / Average Accounts Receivable
2. Inventory Turnover Ratio for Merchandise
This ratio indicates how well a company converts its stock and work-in-progress (WIP) inventory into cash. A greater value usually indicates that the corporation can swiftly sell its inventory to create sales, and vice versa. A stock turnover ratio is another name for the ratio. The cost of sales divided by average inventories is the calculation for merchandise inventory turnover ratio. It is expressed mathematically as,
Merchandise Inventory Turnover Ratio = Cost of Sales / Average Inventories
3. Asset Turnover Ratio Total Asset Turnover Ratio Total Asset Turnover Ratio Total Asset
This ratio measures a company’s ability to produce sales by leveraging all of its long- and short-term assets. A higher value usually indicates that the company can create more sales by leveraging its assets, which is ideal. The total asset turnover ratio is calculated by dividing revenue by the average value of total assets over a specified time period. It is expressed mathematically as,
Total Asset Turnover Ratio = Revenue / Average Total Assets
4. Ratio of Net Fixed Asset Turnover
This ratio demonstrates a company’s ability to create sales by leveraging fixed assets such as plant, property, and machinery. A higher score usually suggests that the company makes good use of its fixed assets. The net fixed asset turnover ratio is calculated by dividing revenue by the average value of net fixed assets over the period. It is expressed mathematically as,
Net Fixed Asset Turnover Ratio = Revenue / Average Net Fixed Assets
Ratios of Activity vs. Ratios of Profitability
To assess a company’s financial health, both activity and profitability ratios should be examined.
Gross margin and operating margin are profitability ratios that show a company’s total capacity to transform sales into earnings after accounting for various expenditures and expenses.
Activity ratios, on the other hand, reflect a company’s capacity to utilize its resources (i.e. assets) efficiently to generate profits on a more granular level (i.e. per asset).
Turnover Ratio for Inventory, Receivables, and Payables
The higher the turnover ratio, the better, because it indicates that the company can create more revenue with fewer assets.
Because most businesses keep a close eye on their accounts receivable (A/R) and inventory fluctuations, these accounts are typically employed 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, each one has the same goal: to measure how efficiently a company can use its operating assets.
Higher profit margins are associated with higher activity ratios, since more value is derived from each asset.
The following are some of the more prevalent ratios:
The number of times a company’s inventory is refilled in a given period is known as inventory turnover.
Receivables Turnover Ratio — The number of times in a given period that a typical client who previously paid on credit (i.e. accounts receivable, or “A/R”) makes a cash payment.
Payables The number of times a corporation pays its due payments to suppliers/vendors (i.e. accounts payable, or “A/P”) in a given period is known as the turnover ratio.
Formulas for Other Activity Ratios
Incorporate Activity Ratios into Your Business
Activity ratios may supply you with information about anything if you use them correctly. It doesn’t matter how swiftly you move product around or how promptly you pay your vendors.
They can also provide useful business statistics, displaying whether or not your company is doing well and assisting you in identifying areas of concern.
If, for example, you observe that your accounts receivable turnover ratio is insufficient, adjusting your credit conditions and determining who is eligible for credit could help you increase the ratio.
If you opt to use your company’s activity ratios, you must do it on a regular basis. A single ratio will offer very little about the performance of your company. Keeping these ratios under check, on the other hand, allows you to spot patterns and solve emerging problems. Compare your ratios to those of similar businesses in the same industry as you analyse them.
It’s not easy to make money in your business. Having the correct tools to promote growth and earnings can go a long way toward ensuring that your company is viable in the short and long run. This job can be made more doable by using techniques like activity ratios.
Activity Ratios’ Limitations and Drawbacks
While activity ratios can be a useful tool for reporting financial ratios, they only provide a small piece of the information needed to establish how well your firm is doing right now.
Activities ratios, like other accounting terms, are primarily concerned with past events. This can provide data on how your business has performed up to a certain point. However, you cannot rely on this data to forecast your company’s future performance.
Furthermore, activity ratios, like any other accounting ratio, provide useful information but cannot solve any current financial difficulties. The data they provide can be misleading when utilised out of context.
Finally, if your financial statements and ratios are incorrect, they will be impacted. As a result, you should begin with the most up-to-date financial statements.