Financial planning and analysis are essential for making informed business decisions and leading your company to long-term success. Activity ratios are among the most helpful financial metrics to incorporate into those processes.
Here’s what you should know about them, including what they are, how to calculate them, and how to interpret them.
What are activity ratios?
Sometimes referred to as efficiency or asset utilization ratios, activity ratios are a type of financial metric designed to measure how effectively your business utilizes its assets to generate revenue.
In other words, activity ratios can help you analyze the relationship between your business’ various assets and its sales. You can use them to identify inefficient aspects of your business and take steps to improve your financial performance.
For example, the inventory turnover ratio is an activity ratio that tells you how many times in a given period your business sells and replaces its entire inventory on average. If yours is low, then it usually takes a long time to turn your stock over.
Given that information, you might decide to lower the number of products you keep on hand to reduce your storage costs and avoid tying up your working capital in your inventory.
Activity ratios vs. profitability ratios.
Activity and profitability ratios are both financial metrics that can help you analyze your business’ performance. However, profitability metrics assess your ability to profit overall, while activity ratios relate your profitability to your assets accounts.
For example, one of the most important profitability ratios is the gross profit margin. It tells you what percentage of your sales you keep after paying off your production costs. Here’s the formula for it:
Gross Profit Margin = (Net Revenues – Cost of Goods Sold) ÷ Net Revenues.
As you can see, it involves only income statement accounts. Meanwhile, activity ratio formulas also incorporate asset accounts from your balance sheet.
Activity ratio formulas.
There are many different types of activity ratios, and their relevance to your business can vary depending on your circ*mstances. Here are some of the ones that many business owners find most beneficial in their financial planning:
- Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory
- Accounts Receivable Turnover Ratio = Net Credit Revenues ÷ Average Accounts Receivable
- Working Capital Turnover Ratio = Net Revenues ÷ Average Working Capital
- Fixed Asset Turnover Ratio = Net Revenues ÷ Average Fixed Assets
- Total Asset Turnover Ratio = Net Revenues ÷ Average Total Assets
You can use these metrics to analyze the relationship between your sales and an asset account. For example, the accounts receivable turnover ratio can help determine how quickly you collect your outstanding invoices.
How to calculate activity ratios.
Let’s go through some examples with real numbers to help you understand how you’d calculate activity ratios in practice. Say you pull the following numbers from your business’s financial statements for the 2020 calendar year:
- Net Cash Revenues: $100,000
- Net Credit Revenues: $100,000
- Cost of Goods Sold: $100,000
- Cash: $8,000 beginning balance and $12,000 ending balance
- Inventory: $20,000 beginning balance and $20,000 ending balance
- Accounts Receivable: $15,000 beginning balance and $25,000 ending balance
- Fixed Assets: $40,000 beginning balance and $60,000 ending balance
- Current Liabilities: $22,500 beginning balance and $27,500 ending balance
First, we must calculate the average balances for each of the balance sheet accounts, using the values at the beginning and end of the year:
Average Cash = ($8,000 + $12,000) ÷ 2 = $10,000
Average Inventory = ($20,000 + $20,000) ÷ 2 = $20,000
Average Accounts Receivable = ($15,000 + $25,000) ÷ 2 = $20,000
Average Fixed Assets = ($40,000 + $60,000) ÷ 2 = $50,000
Average Total Assets = $10,000 Average Cash + $20,000 Average Inventory + $20,000 Average Accounts Receivable + $50,000 Average Fixed Assets = $100,000
Average Current Liabilities = ($22,500 + $27,500) ÷ 2 = $25,000
Average Working Capital = $10,000 Average Cash + $20,000 Average Inventory + $20,000 Average Accounts Receivable – $25,000 Average Current Liabilities = $25,000
Now that we have those results, we can start plugging numbers into the activity ratio formulas. Here’s what you’d get for each one:
Inventory Turnover Ratio = $100,000 Cost of Goods Sold ÷ $20,000 Average Inventory = 5
Accounts Receivable Turnover Ratio = $100,000 Net Credit Revenues ÷ $20,000 Average Accounts Receivable = 10
Working Capital Turnover Ratio = $200,000 Net Revenues ÷ $25,000 Average Working Capital = 8
Fixed Asset Turnover Ratio = $200,000 Net Revenues ÷ $50,000 Average Fixed Assets = 4
Total Asset Turnover Ratio = $200,000 Net Revenues ÷ $100,000 Average Total Assets = 2
Interpreting activity ratios.
Generally, a low activity ratio means you’re using the underlying asset less efficiently, while a high activity ratio means you’re using it more efficiently. However, what counts as ‘low’ and ‘high’ can vary significantly between each activity ratio.
For example, a health inventory turnover ratio is often between 5 and 10, while a healthy fixed asset turnover may be closer to 0.25 to 2.5. Of course, these baselines can also be noticeably different between industries and business models.
For example, grocery stores offer relatively cheap, perishable goods and naturally aim for higher inventory turnover ratios than jewelry stores, which sell expensive products with an indefinite shelf life.
Remember to factor your circ*mstances into your financial analysis and put your results into proper context. That’s the only way to gain meaningful insights from them and make informed strategic decisions.
