What are Activity Ratios?
Activity ratios are a category of financial ratios that measure a firm's ability to convert different accounts within its balance sheets into cash or sales. Activity ratios measure the relative efficiency of a firm based on its use of its assets, leverage, or other similar balance sheet items and are important in determining whether a company's management is doing a good enough job of generating revenues and cash from its resources.
Activity ratios are also commonly known as efficiency ratios.
What do Activity Ratios Tell You?
Companies typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues, so analysts perform fundamental analysis by using common ratios such as the activity ratio. Activity ratios measure the amount of resources invested in a company's collection and inventory management. Because businesses typically operate using materials, inventory, and debt, activity ratios determine how well an organization manages these areas.
Activity ratios gauge an organization's operational efficiency and profitability. These ratios are most useful when compared to a competitor or industry to establish whether an entity's processes are favorable or unfavorable. Activity ratios can form a basis of comparison across multiple reporting periods to determine changes over time.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio determines an entity's ability 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 cash. A low ratio suggests a deficiency in the collection process.
Merchandise Inventory Turnover Ratio
The merchandise inventory turnover ratio measures how often the inventory balance is sold during an accounting period. The cost of goods sold is divided by the average inventory for a specific period. Higher calculations indicate inventory is quickly converted into sales and cash. A useful way to use this activity ratio is to compare it to previous periods.
Total Assets Turnover Ratio
The total assets turnover ratio measures how efficiently an entity uses its assets to make a sale. Total sales are divided by total assets to see how proficient a business is in using its assets. Smaller ratios may indicate that the company is holding higher levels of inventory instead of selling.
The Difference Between Activity Ratios and Profitability Ratios
Activity (efficiency) ratios and profitability ratios are tools used in fundamental analysis. These ratios help investors with their investment decisions, and each indicates something different about a business. Profitability ratios depict how much profits a company is generating, whereas efficiency ratios measure how efficient a company utilizes its resources to generate a profit.
Profitability ratios measure a company's ability to generate profits within a specified context. Profitability ratios measure the overall performance of a company through profits. Profitability ratios are used to compare a company's ability to generate profits relative to its industry, or the same ratios can be compared within the same company for different periods. One ratio used to measure a company's profitability is return on equity (ROE), which measures the amount a company generates with the funds raised from shareholders' equity. It is calculated by dividing net income by shareholders' equity.
For example, an investor can compare the return on investment (ROI) of a company with the average ROE of its industry. He can also compare the ROE for the current fiscal period to a past fiscal period to evaluate how well a company is doing.
On the other hand, efficiency ratios are used to measure how well a company is using its assets and liabilities to generate income. Efficiency ratios are more specific than profitability ratios, using specific measurements of a company to gauge its efficiency. Ratios that are used to measure a company's efficiency include the asset turnover ratio, which measures the amount of revenue a company generates per dollar of assets. It is calculated by dividing a company's sales by its total assets. This reveals how well a company is using its assets to generate sales.