FAM/U4 Topic 3 Activity Ratios
These ratios basically measure the efficiency with which assets are being utilized or managed. This is why they are also known as productivity ratio, efficiency ratio or more famously as turnover ratios.
These ratios show the relationship between sales and any given asset. It will indicate the ratio between how much a company has invested in one particular type of group of assets and the revenue such asset is producing for the company.
The following are the different kinds of activity ratios that measure the effectiveness of the funds invested and the efficiency of their performance
- Stock Turnover Ratio
- Debtors Turnover Ratio
- Creditors Turnover Ratio
- Stock to Working Capital Ratio
1) Stock Turnover Ratio
One of the most important of the activity ratios is the stock turnover ratio. This ratio focuses on the relationship between the cost of goods sold and average stock. So it is also known as Inventory Turnover Ratio or Stock Velocity Ratio.
It basically counts the number of times a stock rotates (completes a cycle) in one given accounting period and the sales it effects in the same period. So it calculates the speed with which the company converts stock (lying about) to sales, i.e. revenue. The formula for the ratio is as follows,
Quick Ratio = COGS / Average Stock
COGS = Sales – Gross Profit
Average Stock = (Opening Stock + Closing Stock)/2
From a managerial standpoint, this is an important ratio to calculate. It allows them to figure out their inventory reordering schedule, by indicating when all the stock will run out. It also helps them analyze how efficiently the stock and its reordering is being managed by the purchasing department.
2) Debtors Turnover Ratio
This ratio measures the efficiency with which Accounts Receivable are being managed, hence it is also known as ‘Accounts Receivable Turnover ratio’. The ratio shows the equation between credit sales (cash sales are not taken into consideration) and the average debtors of a firm. The formula is as below
Debtors Turnover ratio = Credit Sales/Average Debtors OR
Debtors Turnover ratio = Credit Sales/Debtors + Bills Receivable
And with a slight modification, we also derive the average collection period. This will indicate the average number of days/weeks/months in which the payment from the debtor is collected by a firm. The formula for this formula is as below,
Average Collection Period = (Number of days/weeks/months)/Debtors T/O Ratio
Both of these ratios are significant in managing the debtors and bills receivables of a company. Not only do they calculate the velocity with which debtors pay up, they help shape the credit policy of the firm as well.
3) Creditors Turnover Ratio
This ratio shows the relation between credit purchases (cash purchases are ignored in this context) and the average creditors of a company at any given time of the accounting year. This ratio is also the ‘accounts payable turnover ratio’. While calculating the net purchases we will minus any purchase return. The formula is as below,
Creditors Turnover ratio = Credit Purchases/Average Creditors OR
Creditors Turnover ratio = Credit Purchases / (Creditors+ Bills Payable)
Average Creditors = (Opening Creditors + Closing Creditors)/2
Now using the same ratio, we can also calculate the average payment period in the number of days/weeks/months. We only have to modify the ratio a little, and remember this will be expressed as a function of time (days, moths etc)
Average Payment Period = (Number of days/weeks/months)/ (Creditors T/O Ratio)
Again creditors turnover ratio has great importance. It calculates the velocity with which creditors are paid off during the year. It helps the management judge how efficiently the accounts payables are being handled.
4) Working Capital Turnover Ratio
This one of the activity ratios will measure the efficiency with which the firm is using their Working Capital to support their sale volumes. So any excess of current assets over the current liabilities of a firm is their working capital. The formula for the ratio is
Working Capital Turnover ratio = Total Sales / Working Capital
Working Capital = Current Assets – Current Liabilities
A high Working Capital Turnover ratio means that the working capital is being very efficiently utilized. But sometimes it could mean that the creditors of the company are excessive (bringing down the working capital) and this could be a problem in the future. Conversely, a low ratio could mean that there are too many debtors or a very big inventory which is not an efficient use of resources.