What Are the Activity Ratios?
Accurate accounting is essential to determining the health and profitability of your small business. Regardless of the kind of small business you own, maintaining accurate and easy-to-access accounting records will help inform your current and future success.
One way to gauge how efficiently your business is using its resources to generate maximum revenue is activity ratios. This article will delve into what these financial metrics are and how to calculate them.
What Are Activity Ratios?
Activity ratios — often called efficiency ratios — are financial metrics that tell you how efficiently you are leveraging the assets on your balance sheet to generate revenue. There are several types of activity ratios, and each reveals essential information about a particular business asset.
Understanding how to calculate and analyze these activity ratios will give your business an upper hand in dealing with customers and suppliers. The types of activity ratios you can glean from good small business accounting records include the:
- Accounts receivable turnover ratio
- Working capital ratio
- Asset turnover ratio
- Fixed assets turnover ratio
- Inventory turnover ratio
- Days payable outstanding
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio — sometimes referred to as the debtor's turnover ratio — is an accounting metric you can use to determine how effective your business is at collecting money from clients and customers.
To calculate accounts receivable turnover, add the amount you have in accounts receivable at the beginning of a set period — e.g., a quarter — to the amount you have at the end of the same period and divide by two. This gives you your average accounts receivable. Then take the value of your net credit sales for that same period and divide it by the average accounts receivable. The accounts receivable turnover ratio formula is:
|Accounts Receivable Turnover|
A high accounts receivable turnover rate is indicative of:
- A high-functioning accounts receivable department in your organization
- Your customers' ability to satisfy their accounts, making them ripe for additional purchases
- Your company's ability to maintain a positive cash flow, an important metric for banks and other lenders
If you have a low ratio for your accounts receivable turnover, you are basically extending interest-free loans to customers or clients who can't pay on time or have made paying your invoices a low priority. A low accounts receivable turnover ratio indicates that:
- There may be room for improvement in your company's collections efforts
- It may be time to take a closer look at revising your credit policies
- You may need to start examining ways to attract more creditworthy customers
To best determine how your accounts receivable turnover ratio is impacting your business, closely track it over time so that you can observe developing trends and patterns.
Working Capital Ratio
Working capital is needed to keep your business up and running. Understanding your working capital ratio - also called your current ratio - helps you determine how confident you can be that you have the liquidity necessary to meet real-time financial obligations.
To calculate your working capital ratio, simply divide your total current assets by your total liabilities.
|Working Capital Ratio|
A high working capital ratio indicates that your business is financially healthy and is possibly poised for expansion. A low working capital ratio may indicate that you are either having or will soon have some difficulties paying short-term bills.
Asset Turnover Ratio
Companies prosper when they leverage assets effectively to generate sales and produce revenue. If you can buy an item for $1 and then sell it for $3, you will realize a healthy asset turnover ratio on that item.
To calculate your asset turnover ratio - sometimes referred to as a total asset turnover ratio - for a particular year, divide your total sales by your average total assets for the year (the value of your assets at the beginning of the year plus their value at the end of the year, divided by two):
|Asset Turnover Ratio|
The higher your asset turnover ratio, the better job your company is doing using its assets to generate revenue to stay financially healthy. Of course, what constitutes a high asset turnover ratio for your business will depend on the industry sector you are in.
For example, you can expect higher asset turnover ratios in a retail business that enjoys a higher sales volume than you can in a real estate business with large asset values and lower turnovers. The important thing is to track your asset turnover ratio over time so that you can make efficient and operational adjustments as needed to keep your asset turnover ratio in a financially healthy range.
Fixed Assets Turnover Ratio
Some businesses, such as manufacturers, make substantial investments in fixed assets - often referred to as property, plant, and equipment (PP&E) - to operate. These fixed asset investments often comprise the company's largest outlays, and they expect to be able to see a return on these investments. If your business has invested heavily in PP&E, you can gauge how well these assets are performing to increase your bottom line by calculating your fixed assets turnover ratio, also referred to as your FAT ratio.
To calculate your FAT ratio, divide your net sales by your net fixed assets, usually over a one-year period.
|Fixed Asset Turnover Ratio|
The higher the FAT ratio, the more efficient your management team is in managing these investments. It is helpful to monitor this metric internally over the course of several years and, when possible, compare it to the averages for your industry to better gauge how your FAT impacts your financial health.
Inventory Turnover Ratio
Understanding inventory turnover - how many times you replace sold inventory over a particular time period - is invaluable when it comes to assessing past sales performance and planning for the future. Your inventory turnover ratio will help you determine how fast you can sell your inventory, how often you need to replace inventory, and whether you are meeting industry averages. These are all critical metrics for determining how your business is performing.
To calculate your inventory turnover ratio, divide your cost of goods sold (COGS) by the average value of your inventory (your beginning inventory plus your ending inventory, divided by two).
|Inventory Turnover Ratio|
In most cases, the lower your inventory turnover ratio, the weaker your sales. A low inventory turnover ratio could also indicate that you are overstocked. A high ratio, on the other hand, could indicate that sales are robust and/or that you are understocked on items that are selling.
Days Payable Outstanding Ratio
Your days payable outstanding (DPO) ratio indicates how many days it takes you to pay your bills. It is an indication of how well you manage your accounts payable and can reveal whether you are taking advantage of all of the financial payment terms available to you.
To calculate your DPO, multiply your accounts payable (what you owe your vendors) by the length of your accounting period (usually 365 days), then divide by the cost of goods sold.
|Days Payable Outstanding|
|Where length of accounting period = 365 days|
It is important to apply both company and industry knowledge to your interpretation of this metric. For instance, a high DPO can be seen as good for your business. It preserves cash flow that can be used for investments. If your DPO is higher than the industry average, it could mean that you are receiving more favorable credit terms than other similarly situated companies.
A high DPO can also be interpreted in a negative light. If your high DPO is due to a lack of available funds, and if your creditors are unhappy with the length of time it takes you to pay, you could lose access to favorable credit terms and even lose suppliers.
A low DPO could indicate that you are not taking advantage of available credit terms or that you are not being offered competitive credit terms. In either case, further inquiry would be warranted.
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accepted accounting standards.