Accounting ratios compare the relative magnitude of a financial figure to another. These ratios help stakeholders understand a company’s operations better. In most circumstances, accounting ratios require metrics from financial statements. However, these metrics may not provide crucial information on their own. Therefore, by putting them through these ratios, stakeholders can obtain better insights into operations.
In essence, accounting ratios compare two (or more) financial metrics to analyze a company’s operations. These provide a beneficial tool for stakeholders to understand various areas within the company. For example, these may look at profitability, liquidity, efficiency, market value, etc. Another name used for accounting ratios is financial ratios.
The information required to calculate financial ratios come from the financial statements. Usually, these include figures from the balance sheet and income statement.
In some cases, it may also involve the statement of cash flows. Among these ratios, most stakeholders prefer the profitability and liquidity ratios. However, activity ratios may also be crucial in understanding a company’s efficiency.
What are Activity Ratios?
Activity ratios are financial ratios that help measure a company’s efficiency. Companies have various processes which allow them to continue their operations. Usually, these processes are crucial in providing a company with a competitive edge. Therefore, companies must ensure they are as efficient as possible. On top of that, there are various costs associated with inefficient processes that they will seek to avoid.
Activity ratios are crucial in understanding a company’s performance. Stakeholders can use these ratios comparatively with other companies or with historical operations. Either way, they provide valuable insights into whether a company has any wastages in its processes. However, it is crucial to consider them comparatively to make better decisions. On their own, activity ratios do not reveal critical information.
Activity ratios consider various areas within a company. Most importantly, they study a company’s working capital, which includes current assets and current liabilities. However, activity ratios may also appraise fixed assets or total assets. In essence, these ratios concern how efficiently a company manages these resources to run operations smoothly.
Activity ratios usually reveal how a company uses its assets and liabilities internally. Analysts use these ratios to measure a company’s short-term or current performance. More importantly, it provides valuable insights into how efficiently a company uses its assets to generate income. Based on the type of stakeholder, the efficiency ratios used will differ.
How to Calculate Activity Ratios?
Calculating activity ratios is straightforward as the figures required to do so are present in the financial statements. However, stakeholders must decide which activity ratio they want to measure. They have the option to choose from one of the various types of these ratios. Some of these options are available above, with an explanation of how to calculate them.
Accounts Receivables Turnover Ratio
The accounts receivable turnover ratio provides insights into how efficiently a company manages its credit sales. It also shows how many times a company can turn its accounts receivables into cash. Usually, stakeholders prefer this ratio to be high. Stakeholders can calculate the accounts receivable turnover ratio using the formula below.
Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
For example, a company made total credit sales of $100,000. Its average accounts receivable during the period were $10,000. Therefore, its accounts receivable turnover ratio will be 10.0 ($100,000 / $10,000). This ratio measures the company’s efficiency in collecting cash proceeds credit sales. However, it does not reveal critical information unless used comparatively.
Working Capital Turnover Ratio
The working capital turnover ratio analyzes how efficiently a company uses its working capital to generate sales. Working capital usually includes the residual amount after deducting current liabilities from current assets. Once calculated, stakeholders can calculate the working capital turnover ratio using the formula given below.
Working capital turnover ratio = Net sales / Working capital
For example, a company generated total revenues of $250,000. Its working capital at the end of the year was $50,000. Therefore, its working capital turnover ratio will be 5.0 ($250,000 / $50,000). Although this ratio is high, it does not describe how it fares against historical performance.
Asset turnover ratio
The asset turnover ratio is similar to the working capital turnover ratio. However, it requires its total assets instead of considering a company’s working capital. In essence, the asset turnover ratio establishes how efficiently a company uses its total resources to generate sales. Stakeholders can use the following formula for asset turnover ratio.
Asset turnover ratio = Net sales / Average total assets
For example, a company generated total sales of $200,000. Its average total assets during the accounting period were $100,000. Therefore, the company’s asset turnover ratio will be 2.0 ($200,000 / $100,000). Similar to the other ratios above, this ratio can provide better insights if used comparatively.
Fixed asset turnover ratio
The fixed asset turnover ratio is similar to the two above activity ratios. However, it considers a company’s fixed assets instead of the other varieties. The formula for the fixed asset turnover ratio is as below.
Fixed asset turnover ratio = Net sales / (Fixed assets – Accumulated depreciation)
For example, a company generated total net sales of $500,000. Its fixed assets minus accumulated depreciation at the end of the period was $100,000. Therefore, the company’s fixed asset turnover ratio will be 5.0.
Days sales outstanding
The day’s outstanding receivable ratio measures a company’s efficiency in recovering receivable balances. However, it produces the result in terms of the number of days it takes for cash flows to come from a credit sale. Stakeholders can use the following formula for days sales outstanding.
Days sales outstanding = Accounts receivable / Net credit sales x 365
For example, a company had total accounts receivable of $200,000 in its balance sheet. During the year, it made net credit sales of $1,000,000.
Therefore, its days sales outstanding will be 73 days ($200,000 / $1,000,000 x 365 days). Stakeholders can also calculate this ratio monthly. Generally, a higher number is not preferable for this ratio.
Days payable outstanding
The day’s payable outstanding measures the number of days it takes a company to repay its credit suppliers. It is similar to the day’s sales outstanding, except it deals with purchases. Usually, stakeholders prefer this ratio to be higher, although not too much. Stakeholders can use the following formula for days payable outstanding.
Days payable outstanding = Accounts payable / Cost of sales x 365
For example, a company had an accounts payable balance of $50,000 on its balance sheet. During the period, its cost of sales in the income statement was $125,000. Therefore, its days payable outstanding will be 146 days ($50,000 / $125,000 x 365 days). Similar to the above ratio, this ratio is calculatable monthly.
Days sales of inventory
The day’s sales of inventory activity ratio consider the average inventory age. It measures how many days a company holds stock before selling it to customers. Usually, the lower it is, the more stakeholders will prefer it. Stakeholders can use the following day’s sales of inventory formula.
Days sales of inventory = Average inventory / Cost of goods sold x 365
For example, a company had an average stock of $200,000 during a period. Its cost of goods sold was $750,000 for the same period. Therefore, its day’s sales of inventory will be 97 days ($200,000 / $750,000 x 365 days). Although this number is high, stakeholders must use it comparatively to get better results.
Financial ratios allow stakeholders to gain valuable insights into a company’s operations. Of these, activity ratios measure a company’s efficiency in managing its assets and liabilities. There are several of these ratios that stakeholders can use. Some of the most prevalently used activity ratios are given above with how to calculate them.