Accounting ratios such as activity ratios, are financial metrics designed to measure various business efficiencies. Also known as efficiency ratios, activity ratios also measure how efficiently a business uses its assets.
Overview: What are activity ratios?
Activity ratios, more commonly known as efficiency ratios, are used to measure the overall efficiency of a business. Activity ratios help business owners see how well they’re managing their assets, and if they’re able to generate income from those assets.
Useful for measuring performance against similar businesses, activity ratios are also useful for tracking business performance over a period of time.
7 types of activity ratios
Business owners use several activity ratios for a variety of reasons. We’ve picked out seven of the most common, providing you with the ratio formula as well as details on what the results of those calculations actually mean.
All calculation examples are based on an accounting period of one year, but you can calculate these ratios monthly or quarterly. Keep in mind that accounting software will automate many of these calculations, but it’s still important to understand the calculation process.
- Accounts receivable turnover ratio
- Inventory turnover ratio
- Fixed asset turnover ratio
- Total assets turnover ratio
- Accounts payable turnover ratio
- Average collection period ratio
- Working capital ratio
Type 1: Accounts receivable turnover ratio
The accounts receivable turnover ratio measures how effectively your business collects money owed from customers. The formula for calculating the accounts receivable turnover ratio for your business is:
Net Credit Sales ÷ Average Accounts Receivable = Accounts Receivable Turnover
Take these steps to take to calculate this ratio:
Step 1: Obtain your credit sales amount from your income statement. If you only sell on credit, you can use the sales figure on the income statement, but if you also have cash sales, you’ll need to subtract them from your total.
December 31, 2020 Income Statement
Based on the income statement, we’ll assume that $135,000 is your total credit sales for the year.
Step 2: Run a beginning and ending balance sheet for the period. This means you’ll run a balance sheet as of January 1, 2020, and a second balance sheet as of December 31, 2020. This will provide you with beginning and ending accounts receivable balances.
Step 3: Calculate your average accounts receivable balance. For the purpose of this calculation, let’s say that your January 1, 2020, accounts receivable balance was $29,000, while the December 31, 2020, balance was $31,000.
$29,000 + $31,000 ÷ 2 = $30,000
You’re now ready to calculate your ratio.
Step 4: Calculate the accounts receivable turnover ratio.
From the numbers above, your calculation will be:
$135,000 ÷ $30,000 = 4.5%
The result means your accounts receivable balance turned over 4.5 times during the year. An accounts receivable ratio under 10 indicates poor credit decisions and inadequate collection processes.
If you’re a new business owner, it’s important to track this number over time to determine if it increases once your collections processes have been perfected.
Type 2: Inventory turnover ratio
The inventory turnover ratio is an important metric for retail businesses that need to see how their inventory is performing. The inventory turnover ratio calculation is:
Cost of Goods Sold ÷ Average Inventory = Inventory Turnover Ratio
Let’s use the following example to calculate inventory turnover.
Jim’s business had average inventory in the amount of $45,000 for the year. He was able to obtain his average inventory by running a balance sheet as of January 1, 2020, and December 31, 2020.
Jim’s cost of goods sold for the year totaled $175,000, a number he was able to obtain from his income statement. The inventory ratio calculation is:
$175,000 ÷ $45,000 = 3.88%
Jim’s inventory turnover for the year was 3.88%, meaning his inventory turned over almost four times during the year. A lower inventory turnover ratio may indicate sluggish inventory movement, while a higher ratio indicates good product demand.
Type 3. Fixed asset turnover ratio
Asset management ratios such as the fixed asset turnover ratio measures how well your business uses its assets in order to generate sales. The fixed asset turnover formula is:
Net Sales ÷ Average Fixed Assets = Fixed Asset Turnover
To calculate the fixed asset turnover ratio, calculate net sales, which is gross sales minus returns and allowances. Net sales totals are always found on your income statement.
$125,000 – $1,500 (returns) – $500 (allowances) = $123,000 Net Sales
Next, run a beginning and an ending balance sheet for the year to obtain your average fixed assets for the year.
$6,000 (beginning balance) + $8,000 (ending balance) ÷ 2 = $7,000 average fixed assets
With net sales of $123,000 and a fixed assets average of $8,000, you can calculate your fixed asset turnover ratio:
$123,000 ÷ $8,000 = 15.75%
A fixed asset turnover ratio of $15.75% means that for every dollar in fixed assets, your business is earning nearly $16. A high ratio indicates that you’re managing your fixed assets properly, while a lower ratio indicates sluggish sales with a high amount of fixed asset investments.
Type 4: Total assets turnover ratio
Like the fixed asset turnover ratio, the total assets turnover ratio measures the ability of a business to generate profits from assets, with the difference being that this ratio uses total assets in the formula, rather than only fixed assets.
The total asset turnover formula is:
Net Sales ÷ Average Total Assets = Total Assets Turnover Ratio
Using the $123,000 in net sales from above, your next step is to calculate your average total assets. Run a balance sheet for the beginning of the year and the end of the year.
Let’s say your beginning assets are $11,000, while your ending assets are $13,000, which means your average net assets total $12,000 for the year. Your total assets turnover ratio would be:
$123,000 ÷ $12,000 = 10.25%
The above result indicates that each dollar of assets currently generates $10.25 in sales for your business. A lower ratio (less than 1) can indicate that assets are not being used efficiently, while a higher number indicates that management is using assets efficiently.
Type 5: Accounts payable turnover ratio
The accounts payable turnover ratio indicates how quickly your company pays off creditors. Though you can calculate this ratio monthly or quarterly, it’s more useful if calculated for the entire year. The formula to calculate accounts payable turnover ratio is:
Total Purchases ÷ Average Accounts Payable = Accounts Payable Turnover Ratio
To calculate this ratio, calculate purchases that were made on credit for the year, eliminating any purchases that were paid immediately. Then run a balance sheet for the beginning and end of your fiscal year in order to obtain beginning and ending balances.
In this example, credit purchases for the year were $44,000. Your beginning accounts payable balance was $9,500, while the ending balance was $11,500, making your average accounts payable balance $10,500.
$44,000 ÷ $10,500 = 4.19%
The result means that your accounts payable balance turned over approximately four times during the year.
The higher your accounts payable turnover ratio is, the more favorable the company looks to investors and creditors, while a lower ratio indicates slow payment and makes your business more of a credit risk.
Type 6: Average collection period ratio
This is an important ratio for businesses that want to see how quickly they’re able to collect on their accounts receivable. The formula to calculate the average collection period ratio is:
Days in Period x Average Accounts Receivable ÷ Net Sales = Average Collection Period Ratio
If you’re calculating this ratio for the year, you’ll use 365 days as your days in period total. Like the other ratios, you can obtain the average accounts receivable number from a beginning and ending balance sheet for the period. You’ll then need to obtain your net sales from your income statement to calculate the ratio.
Since we’re calculating for the year, we’ll use 365 days. The beginning accounts receivable balance for the year was $22,000, while the ending accounts receivable balance was $15,000, making the average accounts receivable balance $18,500, while net sales for the year was $187,500.
365 x $18,500 ÷ $187,500 – 36.01%
This means, on average, it’s taking your business 36 days to collect on an invoice. The lower the ratio, the quicker you’re collecting on accounts receivable, while a high number indicates that your customers are slow to pay.
Type 7: Working capital ratio
Your working capital ratio tells you how much money your company has available to cover operating expenses for the year. The working capital ratio is a simple formula:
Current Assets ÷ Current Liabilities = Working Capital Ratio
For example, if your current assets for the year total $145,000, and your current liabilities are $77,000, your working capital ratio would be:
$145,000 ÷ $77,000 = 1.88%
That means for every current $1 you have in liabilities, you have $1.88 in current assets available. Working capital ratios vary for each industry, so it’s best to compare your current working capital ratio to others in a similar industry.
Activity ratios are an important part of doing business
The best way to remain in business for the long term is to learn how efficient your business is operating, and the best way to do that is by calculating activity ratios.
These ratios can tell you everything from how quickly your customers are paying their bills to how quickly you’re paying yours. They also tell you if you’re using your assets to earn more money, or if they’re underutilized.
Best when used to compare performance with other similar businesses, activity ratios should also be calculated regularly in order to view any upward or downward trends. In any case, if you plan to grow your small business, activity ratios should be a part of that growth.
View more information: https://www.fool.com/the-blueprint/activity-ratios/