• # Activity ratios

Activity ratios are related to the daily operations of a company which are used to analyze the efficiency of the company and the management to generate cash faster from the business operations.

During its daily business operations the company

1. Buy the raw materials and inventories from the suppliers and pay them cash for the same. The cash amount to be paid to the suppliers comes under the payable section.
2. All the payables have to be cleared within a certain period set by the suppliers. For companies with better rating and good will the payable period is more compared to other companies.
3. Then the company develops the end products using the inventory or the raw materials. The faster it converts the inventories to the end products; it is termed as more efficient.
4. After that the company sells its products through selling network or sell to some other company. The amount to be received as the sell value of its products is called receivables.
5. Company gets all the receivables money cleared within a specific period of time which is based on the company standard or the buyer company standard.
6. After receiving the receivables, the company pays the payable amount to the suppliers and keeps the extra amount as profit.
7. This is how the company converts the raw materials into products and earns cash on the same. This is the normal activity of a company to generate profit over the course of time.
8. The faster the company generate profits, better for the company

The main ratios used to check the activity of a company are

Receivables Turnover measures the number of times the receivables payments are received within a year. It shows how many times the company sells its final products in a year and receives the receivables from the end-product buyers.

It is calculated as

Receivables Turnover (Days) = Annual Sales Revenue / Average Receivables

The receivables turnover varies from one industry to another one, but the company should maintain a receivable turnover near to the industry standard. The higher receivables turnover indicates better operation for the company.

Average collection period or the Days of Sales Outstanding is calculated as 365 days divided by receivables turnover to get the average number of days used to collect all the receivables from the debtors.

Average collection period = 365/ Receivables Turnover (Days)

The average collection period should be maintained near to the industry standard. Too high collection period means the      customers are very slow to pay their bills and high amount of money are stuck with them every time which hampers the production activity. Too low average collection period means the company’s credit policy is very tough and rigorous and this adverse policy can put pressure on the customers and hamper sales.

Inventory Turnover measures the company’s efficiency to process all the stored inventories within the proper time. Higher the inventory turnover; better the company’s operational efficiency to produce the end products.

Inventory Turnover = Cost of Goods Sold / Average Inventories

It shows how many times the company orders for the inventories in a year. Too much order increases the transportation cost and too less order increases the storage cost of the inventories. It is always better to use the industry standard inventory turnover ratio.

Average Inventory Processing Period or Days of Inventory on Hand is calculated from 365 days by dividing the inventory turnover.

Average Inventory Processing Period = 365/ Inventory Turnover

This Average Inventory Processing Period should be kept near to the industry standard. Too high Average Inventory Processing Period means the company is holding huge inventories all the time which increases the storage cost and holds to much cash with the same. Too low Average Inventory Processing Period means the company does not keep sufficient stocks all the time which increases the number of orders and transportation cost and also makes the company’ inventory stock vulnerable during any supply crisis.

Payables Turnover measures the number of times the payables are paid within a year. It shows how many times the company pays to the suppliers for the inventories in a year and receives the inventories or raw materials.

It is calculated as

Payables Turnover (Days) = Annual Purchases / Average Payables

The payables turnover varies from one industry to another one, but the company should maintain a payables turnover near to the industry standard. The higher payables turnover indicates better operation for the company.

Payables Payment Period or Number of Days of payables is calculated as 365 days divided by payables turnover to get the average number of days used to pay all the payables to the creditors or suppliers.

Payables Payment Period = 365/ Payables Turnover (Days)

The Payables Payment Period should be maintained near to the industry standard. Too high Payables Payment Period means the company is facing liquidity crisis and have to depend on receiving receivables to pay the suppliers. This decreases the confidence among the suppliers and creditors. Too low Payables Payment Period means the company is not able to utilize the cash properly and some growth opportunity may not be utilized.

Working Capital mainly denotes the cash amount which is involved in the daily operations of a company and calculated as the difference between current assets and current liabilities. Working Capital Turnover Ratio shows how efficiently the company is using its working capital. It is calculated as

Working Capital Turnover = Sales Revenue / Average Working Capital

Working capital turnover ratio can be checked to know about the efficiency of the company, but it is not so widely used parameter to check the operational activity of a company as it varies significantly from one period to another one.