Financial Management & Cost Accounting

Module 4. Financial statement analysis

Lesson 21
ACTIVITY RATIOS

21.1 Meaning of Activity Ratio

Accounting ratios that measure a firm's ability to convert different accounts within their balance sheets into cash or sales. Companies will typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues.
Such ratios are frequently used when performing fundamental analysis on different companies. The asset turnover ratio and inventory turnover ratio are good examples of activity ratios.

Activity ratios measure company sales per another asset account—the most common asset accounts used are accounts receivable, inventory, and total assets. Activity ratios measure the efficiency of the company in using its resources. Since most companies invest heavily in accounts receivable or inventory, these accounts are used in the denominator of the most popular activity ratios.

Accounts receivable is the total amount of money due to a company for products or services sold on an open credit account. The accounts receivable turnover shows how quickly a company collects what is owed to it.

Accounts Receivable Turnover = Total Credit Sales/ Accounts Receivable

For a company to be profitable, it must be able to manage its inventory, because it is money invested that does not earn a return. The best measure of inventory utilization is the inventory turnover ratio (aka inventory utilization ratio), which is the total annual sales or the cost of goods sold divided by the cost of inventory.

Inventory Turnover = Total Annual Sales or Cost of Goods Sold/ Inventory Cost

Using the cost of goods sold in the numerator is a more accurate indicator of inventory turnover, and allows a more direct comparison with other companies, since different companies would have different markups to the sale price, which would overstate the actual inventory turnover.

Average Total Assets = Assets at Beginning of Year + Assets at End of Year / 2

Total Asset Turnover = Net Sales / Average Total Assets

It shows how much revenue is generated for each dollar invested in assets.

Financial ratios which measure how effectively a firm is using its assets. Examples include accounts receivable turnover, asset turnover, and inventory turnover ratios.

21.2 Activity Ratio

An indicator of how rapidly a firm converts various accounts into cash or sales. In general, the sooner management can convert assets into sales or cash, the more effectively the firm is being run.

Activity Analysis Ratios

Assets Turnover Ratio = Sales/ Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2

Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable

Average Accounts Receivable

= (Beginning Accounts Receivable + Ending Accounts Receivable) / 2

Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories

Average Inventories = (Beginning Inventories + Ending Inventories) / 2