What are the activity ratios?
Activity ratios are a category of financial ratios that measure a company’s ability to convert different balance sheet accounts into cash or sales. Activity ratios measure the relative efficiency of a business based on its use of assets, leverage or other similar balance sheet items and are important in determining whether the management of a business is doing enough well to generate income and cash from its resources.
Activity ratios are also known as efficiency ratios.
What do the activity ratios tell you?
Companies usually try to turn their production into cash or sales as quickly as possible, as this will usually lead to an increase in revenue, so analysts perform fundamental analysis using common ratios such as the activity ratio. Activity ratios measure the amount of resources invested in collecting and managing a company’s stocks. Since businesses typically operate using materials, inventory, and debt, activity ratios determine how well an organization manages these areas.
Activity ratios measure the operational efficiency and profitability of an organization. These ratios are most useful when compared to a competitor or industry to determine whether an entity’s processes are favorable or unfavorable. Activity ratios can be used as a basis for comparison across multiple reporting periods to determine changes over time.
Examples of activity ratios include the total asset turnover ratio and inventory turnover. The following activity ratios can be analyzed as some of the main performance indicators of an organization.
Debtor turnover ratio
The debtor turnover rate determines the ability of an entity to collect money from its customers. Total credit sales are divided by the average accounts receivable balance for a specific period. This activity ratio calculates management’s ability to receive money. A low ratio suggests a gap in the collection process.
Commodity inventory turnover ratio
The inventory turnover rate measures the frequency with which the inventory balance is sold during an accounting period. The cost of goods sold is divided by the average stock for a specific period. Higher calculations indicate that inventory is quickly converted to sales and cash. A useful way to use this activity rate is to compare it to previous periods.
Total asset turnover ratio
Total asset turnover measures the efficiency with which an entity uses its assets to make a sale. Total sales are divided by total assets to see how well a business is using its assets. Lower ratios may indicate that the business has higher inventory levels rather than selling.
Activity ratios are an important category into which a ratio can be classified; other ratios can be classified as measures of liquidity, profitability or leverage.
The difference between activity ratios and profitability ratios
Activity (efficiency) ratios and profitability ratios are tools used in fundamental analysis. These ratios help investors in their investment decisions, and each indicates something different about a company. Profitability ratios describe the profits a business generates, while efficiency ratios measure the efficiency with which a business uses its resources to generate profit.
Profitability ratios measure the ability of a business to generate profits in a specified context. Profitability ratios measure the overall performance of a business through profits. Profitability ratios are used to compare the ability of a business to generate profits relative to its industry, or the same ratios can be compared within the same business for different periods. A ratio used to measure the profitability of a business is the return on equity (ROE), which measures the amount that a business generates with funds from equity. It is calculated by dividing the net income by equity.
For example, an investor can compare a company’s return on investment (ROI) with the average ROE of its industry. It can also compare the ROE of the current financial year to a previous financial year to assess the performance of a company.
On the other hand, efficiency ratios are used to measure the extent to which a business uses its assets and liabilities to generate income. Efficiency ratios are more specific than profitability ratios, using company-specific measures to assess its effectiveness. The ratios used to measure the efficiency of a business include the asset turnover rate, which measures the amount of revenue that a business generates per dollar of assets. It is calculated by dividing a company’s sales by its total assets. This shows how much a business uses its assets to generate sales.