(3) Activity Ratios
Activity ratios are those used to measure the efficiency by which the company’s management conducts its business operations and harness its resources to optimize the earning potentials of the business. These ratios include but are not limited to the following:
Inventory Turnover Ratio Formula
Cost of Goods Sold ⁄ Average Inventory
Average Inventory = Present Year’s Inventory Balance + Previous Year’s Inventory Balance / 2 years
The result of this ratio will be interpreted as the number of inventory unit sold as against the number of inventory units left unsold. Hence if the company’s cost of goods sold is $100.000 and the average inventory on hand is 20,000, the resulting ratio is 5:1 on the average scale. It means that for every 6 units of goods held for resale, 5 units were sold during the year and an average of 1 unit remains on hand.
Days Inventory on Hand
365 days ⁄ Inventory Turnover
This is an estimation of the number of days that a non-performing inventory is held. A high number would mean inventory management needs improvement, while stock held as inventory should be examined. A high ratio may be indicative that a substantial amount of funds is being tied down by slow moving stocks.
Accounts Receivable Turnover Ratio Formula
Revenue from Sales ⁄ Average Accounts Receivable
Average Accounts Receivable = Present Year’s Accounts Receivable Balance + Previous Year’s Accounts Receivable Balance / 2 years
The resulting ratio will be interpreted as the amount of goods sold in cash versus for every unit sold on credit basis. It is important that the average balance of accounts receivable is minimal to achieve favorable results. To illustrate an unfavorable AR Turnover ratio: Revenue from Sales $200,000, average receivable balance for two years is $ 115,000 and the resulting ratio is 1.74: 1
It reveals that for every dollar of sales made on credit, there is only an equivalent sales of $ 1.74. This means a large part of the sales efforts go into receivables instead of cash.
Days Sales Outstanding
365 days ⁄ AR Turnover
This will provide the number of days it takes the company to collect from the customer.
Accounts Payable Turnover
Purchases on Credit ⁄ Accounts Payable Balance
The resulting ratio will reveal the ratio and proportion of a credit purchase to its remaining balance, to indicate the company’s ability to pay for its stock inventory during a year. To get the days payable, the number of days in a year will be divided by the AP turnover.
Please proceed to the next page for the explanations about Cash Flow Ratios and Solvency Ratios.