What is Activity Ratios

Activity Ratios

Activity Ratios

Generally, activity means a particular direction in which a business applies its efforts, e.g., a business may have a trading activity or a manufacture activity. In accounting, activity is a measure of the general level of business. Thus a firm with a small turnover may be said to be operating at a low level activity.

Activity ratios show the degree of assets utilisation of a business. Activity are the ratios of the cash elasticity of current assets, i.e., how quickly various current assets are converted into sales and cash. Current assets normally comprise cash, debtors and stock. A firm’s ability to meet current liability largely depends upon the rate at which cash flows into the business from current operations. Since sales are the critical event in this respect, the rate at which stock are sold or debtors settle their accounts are very crucial. Thus, it is necessary to evaluate the activity of specified current assets like stock, debtors and also total assets. The important activity ratios are as under:

Inventory / Stock Turnover Ratio

Meaning of inventory / stock turnover ratio: This is the ratio between the stock of finished goods and the cost of goods sold (we have to take the cost of goods sold, not the sales figures itself, so that both figures are expressed in the same method of valuation – cost). The stock turnover ratio measures how quickly stock is sold, i.e., the number of time a company’s stock turnover during a year.

Formula of Inventory / Stock Turnover Ratio = Cost of goods sold/Average Stock = Number of times

Notes:

(1) Cost of goods sold = Sales – Gross Profit

Cost of goods sold = Opening Stock + Purchase + Carriage Inwards + Direct Expenses – Closing Stock

(2) When both sales and stock fluctuate widely from month to month, a misleading ratio cloud result from companies year and stock with the cost of goods sold. One solution would be to use an average stock. Average stock is calculated as follows:

Method 1 Average Stock = Opening Stock + Closing Stock/2

Method 2 Average Stock = Total of Monthly Stocks/12

(The information to calculated average stock by the method 2 is rarely available in examination questions. Therefore, it is better to follow method 1.)

Significance of inventory / stock turnover ratio

Significance of Inventory / Stock Turnover Ratio

Other things remaining the same, a high stock turnover ratio indicates a low level of stock and that increase profit. A low stock turnover ratio is an indication of the maintenance of a very high level of stock and, in effect, the business will face the problems of over-stocking. However, the nature of a company’s business obviously affects its speed of stock turnover. For Example, a supermarket can move its stock faster than a car dealer.

Debtors Turnover Ratio

Meaning of debtors turnover ratio: This is the ratio between credit sales (if the information in regarding to credit sales is not available, total sales may be taken in credit sales) and average debtors plus average bills receivable. This ratio indicates the numbers of times per year that the average balances of debtors are collected.

Formula of Debtors Turnover Ratio = Credit Sales/Average Debtors + Average Bills Receivable

= Number of Times Debtors Collected each year

Significance of debtors turnover ratio

Significance of Debtors Turnover Ratio

A high debtors turnover ratio may indicates an improvement in business conditions, a tightening of credit policies, or improved collection procedures. A low ratio may be indication of long credit period or slow realisation from debtors.

Debtor Collection Period

It provides a rough approximation of the average time that it takes to collect debtors. It is computed by dividing 365/12 by the number of debtors turnover. It is determined as follows:

Debt Collection Period = 365/Debtors’ Turnover = Number of Days

Debt Collection Period = 12/Debtors’ Turnover = Number of Months

The debtors turnover ratio and debt collection period are often use to measure a business’s ability to meet short term obligation and measure the strength of the business’s current operation. In other words, they can be use as indicators of how quickly the debtors are converted into cash required for operation and debt repayment.

Payable / Creditors Turnover Ratio

Meaning of creditors turnover ratio: This is the ratio between credit purchases (if the information to regard credit purchases is not available, total purchases may be taken in the place of credit purchases) and average creditors plus average bills payable. This ratio indicates the numbers of times per year that the average balances of creditors are paid.

Formula of Creditors Turnover Ratio = Credit Purchases/Average Creditors + Average Bills Payable

= Number of Times Creditors are paid each year

Significance of creditors turnover ratio

Significance of Creditors Turnover Ratio

A high creditors turnover ratio may indicates strict credit terms generated by the suppliers. A law ratio may be indication of liberal credit terms granted by the suppliers.

Average Payment Period: It provides a rough approximation of the average time taken to pay back the creditors. It is compute by dividing 365 or 12 by the number of creditors turnover. It is determined as follows:

Debt Payment Period = 365/Creditors’ Turnover = Number of Days

Debt Payment Period = 12/Creditors’ Turnover = Number of Months

Working Capital Turnover Ratio

Meaning of working capital turnover ratio: This is the ratio between turnover (sales) and working capital (current assets less current liabilities). This ratio shows the extent to which a business is using its working capital to generate sales.

Formula of Working Capital Turnover Ratio = Net Sales or Turnover/Working Capital = Number of Times

Significance of working capital turnover ratio

Significance of Working Capital Turnover Ratio

This ratio indicates the number of times the working capital has been turned over or utilised during the period. A high ratio indicates efficient use of working capital in generating sales. A low ratio is an indication of inefficiency of working capital management.