Activity ratios are also known as asset utilization ratios or operating efficiency ratios. This category is intended to measure how well a company manages various activities and various assets. Activity ratios are analyzed as indicators of ongoing operational performance how effectively assets are used by a company. These ratios reflect the efficient management of both working capital and longer term assets.
The following table presents the most commonly used activity ratios. The exhibit also shows the numerator and denominator of each ratio.
Activity ratios measure how efficiently the company utilizes assets. They generally combine information from the income statement in the numerator with balance sheet items in the denominator. Because the income statement measures what happened during a period whereas the balance sheet shows the condition only at the end of the period, average balance sheet data are normally used for consistency.
Performance ratios help to determine how well management is operating the business. Operating efficiency ratios are comprised of the total asset turnover, net fixed asset turnover. All of these ratios take some asset and divide it into sales to determine how efficiently the company uses assets and capital.
1. Total asset turnover - The effectiveness of the firm's use of its total assets to create revenue is measured by the total asset turnover. Total Asset turnover may vary from industry to industry. In a capital intensive industry it may be close to 1 whereas in a services industry it can be very high. It is desirable for an asset turnover to be close to the industry norm. Low asset turnover ratios might mean that the company has too much capita l tied up in it s asset base. A turnover ratio that is too high might imply that the firm has too few asset s for potential sales or that the asset base is outdated.
2. Fixed asset turnover – As is the case with the total asset turnover ratio, it is desirable to have a fixed asset turnover close to the industry norm. Low fixed asset turnover might mean that the company has too much capital tied up in its asset base and the sales are not adequate to generate optimum profits. A turnover ratio that is too high might imply that the firm has obsolete equipment and the firm will probably have to incur capital expenditures in the near future to increase capacity to support growing revenues.
3. Inventory turnover and Days of inventory on hand - Inventory turnover lies at the core and most important ratio to consider for many entities. It indicates the resources or money tied up in inventory (carrying costs) and can, therefore, be used to indicate inventory management effectiveness. The higher the inventory turnover ratio, the shorter the period that inventory is held and so the lower Days of inventory on hand and vice versa.
A high inventory turnover ratio relative to industry norms might indicate highly effective Inventory management. Alternatively, a high inventory turnover ratio (and low DOH) could possibly indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue. To assess which explanation is more likely, one should compare the company’s revenue growth with that of the industry. Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Revenue growth at or above the industry’s growth supports the interpretation that the higher turnover reflects greater inventory management efficiency.
Receivables turnover and Days of sales outstanding - The number of Days of sales outstanding represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers it offers credit. Although limiting the numerator to sales made on credit would be more appropriate, credit sales information is not always available; therefore revenue as reported in the income statement is generally used as an approximation.
Payables turnover and the Number of Days of Payables- The number of days of payables shows the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors. A payables turnover ratio that is high (low days payable) relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. An excessively low turnover ratio (high day’s payable) could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms.
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