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5.5: Activity Ratios

  • Page ID
    83381
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    Video - Audio - YouTube (Activity Ratios start on slide 32.)

    Activity Ratios are used to relate how well a firm is managing its assets. Activity ratios measure a firm’s ability to convert different accounts within their balance sheets into cash or sales. Companies will try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues. These ratios utilize entries from both the Balance Sheet and Income Statement.

    Accounts Receivable Turnover

    Accounts Receivable Turnover is a measure of how well Accounts Receivable are managed. Businesses often will deliver goods or services but accept payment later. Accounts Receivable are the amounts that are owed to the business for those goods and services.

    Total Revenue
    Accounts Receivable Turnover = ———————————————————————
    Accounts Receivable

    The higher the number, the better. It indicates the return a company is getting from its investment in accounts receivable. By maintaining accounts receivable, firms are indirectly extending interest free loans to their clients. A high ratio implies that the company operates either on a cash basis, or its extension of credit and collection of accounts receivable is efficient. A low ratio implies that the company should reassess its credit policies in order to ensure the timely collection of imparted credit not earning interest for the firm. Or that may just be how that industry operates. An example of this is the Defense industry. Uncle Sam will eventually get around to paying you for that aircraft carrier you built for him. But he does take his good old sweet time. The large Defense contractors are used to this but smaller contractors often have a difficult time waiting since they simply do not have the same amount of resources. Some years ago, the small contractors complained bitterly and it is our understanding that the government has stepped up the payment time frame.

    Initially, we could guess that a retail grocer such as Sprouts would not have a significant sum in Accounts Receivable and we would be correct. Accounts Receivable for Sprouts is only 33,210. Dividing the Total Revenue of 6,100,000 by the Accounts Receivable of 33,210 gives us an Accounts Receivable Turnover of 183.680. This means that over 183 times per year, Sprouts turns over their Accounts Receivable. That is every two days. There is no problem here!

    Inventory Turnover

    Inventory Turnover is very important to many industries. It is a measure of how a company manages its Inventory.

    Total Revenue
    Inventory Receivable Turnover = —————————————————
    Inventory

    The higher the number, the less time an item spends in inventory and the better the return the company is able to earn from funds tied up in inventory. As with all ratios, this ratio must be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective inventory buying or maintenance. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble in the case of falling prices or obsolete products.

    With a Total Revenue of 6,100,000 divided by the Inventory of 265,390, we see that the Inventory Turnover for Sprouts is 22.985. Sprouts is turning over their Inventory approximately every two weeks. If you shop at Sprouts and come back two weeks later, virtually all the products you see on the shelves have been replaced. Obviously, some high-volume products are being replaced daily while others are replaced much less frequently. However, you get the idea. The high Inventory Turnover relieves much of the concern we initially had with the low Acid-test Ratio above.

    Total Assets Turnover

    Total Asset Turnover measures how well the company manages its total assets.

    Total Revenue
    Total Assets Turnover = ————————————————
    Total Assets

    The Total Assets Turnover Ratio measures the firm’s efficiency at using assets to support sales and revenue, the higher the number the better. Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover. With Sprouts, we take the Total Revenue of 6,100,000 and divide the Total Assets of 3,280,000 and get a Total Asset Turnover of approximately 1.86. Sprouts is turning over their total assets about twice a year.


    This page titled 5.5: Activity Ratios is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.