What Is an Activity Ratio?
An activity ratio is a type of financial metric that indicates how efficiently a company is leveraging the assets on its balance sheet, to generate revenues and cash. Commonly referred to as efficiency ratios, activity ratios help analysts gauge how a company handles inventory management, which is key to its operational fluidity and overall fiscal health.
- An activity ratio broadly describes any type of financial metric that helps investors and research analysts gauge how efficiently a company uses its assets to generate revenues and cash.
- Activity ratios may be utilized to compare two different businesses within the same sector, or they may be used to monitor a single company's fiscal health over time.
- Activity ratios can be subdivided into merchandise inventory turnover ratios, total assets turnover ratios, return on equity measurements, and a spectrum of other metrics.
Understanding Activity Ratios
Activity ratios are most useful when employed to compare two competing businesses within the same industry to determine how a particular company stacks up amongst its peers. But activity ratios may also be used to track a company's fiscal progress over multiple recording periods, to detect changes over time. These numbers can be mapped to present a forward-looking picture of a company's prospective performance.
Activity ratios can be broken down into the following sub-categories:
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. 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 suggest that a company can move its inventory with relative ease.
Total Assets Turnover Ratio
The total assets turnover ratio measures how efficiently an entity uses its assets to tender a sale. Total sales are divided by total assets to decipher how proficiently a business uses its assets. Smaller ratios may indicate that a company is struggling to move its products.
Return on Equity
A performance metric knows as return on equity (ROE) measures the revenues raised from shareholder equity. ROE is calculated by dividing net income by all outstanding stock shares in the market.
Asset Turnover Ratio
A metric called the asset turnover ratio measures the amount of revenue a company generates per dollar of assets. This figure, which is simply calculated by dividing a company's sales by its total assets, reveals how efficiently a company is using its assets to generate sales.
Activity Ratios Vs. Profitability Ratios
Activity ratios and profitability ratios are both fundamental analytical tools that help investors evaluate different facets of a company's fiscal strength. Profitability ratios depict a company's profit generation, while efficiency ratios measure how well a company utilizes its resources to generate those profits. Profitability ratios may help analysts compare a company's profits with those of its industry competitors, while also tracking the same company's progress across several different reporting periods.