Activity ratios 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.
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.
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.
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.
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.