Activity Ratios
Meaning of Activity Ratios (Turnover Ratios)
The turnover ratios help in checking the capacity of the business to make more sales or turnover. Higher turnover ratio means better utilization of assets and improved efficiency and profitability, so, also known as efficiency ratios.
The important activity ratios are:
1. Inventory Turnover ratio.
2. Receivables Turnover ratio.
3. Payables Turnover ratio.
4. Net Assets Turnover ratio.
5. Fixed Assets Turnover ratio. (4.a below)
6. Working Capital Turnover ratio. (4.b below)
1. Inventory Turnover Ratio
It expresses the relationship between the cost of goods sold and stock of goods.
Inventory Turnover Ratio = Cost of revenue from operations/ Average Inventory
Average Inventory = (Opening Inventory+ Closing Inventory)/2
Cost of Revenue from Operation = Revenue from Operation – Gross Profit
or
Opening Inventory + Net Purchases + Direct Expenses (Assume to be given) – Closing Inventories
or
Cost of materials consumed + Purchase of stock-in-trade + Change in Inventory (Finished Goods; Work in Progress & Stock-in-trade) + Direct Expenses (Assume to be given)
Significance:
It helps us to know the frequency of conversion of stock of finished goods into sales. It determines how many times stock is purchased or replaced during a year.
Higher ratio is considered better but very high ratio shows over trading and low ratio means stock is piled up or over investment in stock.
2. Receivables Turnover Ratio
It expresses the relationship between credit sales and debtors.
Receivables Turnover ratio = Credit revenue from operations/ Average Trade Receivables
Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable)/2
Precaution: Debtors should be taken before making any provision for doubtful debts.
Significance:
The liquidity position of the firm depends upon the speed with which debtors are realized. This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting period.
Higher turnover ratio means speedy collection from debtors.
Average collection period= (365 days or 12 months)/Debtors turnover ratio.
3. Payables Turnover Ratio
It expresses the relationship between net credit purchases and average accounts payable.
Payables Turnover ratio = Net Credit purchases/ Average accounts payable
Average account payable = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)/2
Significance:
Creditors turnover ratio indicates the pattern of payment of accounts payable.
Higher turnover ratio indicates early payments. Whereas low ratio indicates delayed payments to suppliers which is not a very good policy as it may affect the reputation of the business.
Average payment period = (365 days or 12months)/Payables turnover ratio.
Shorter average payment period means credit allowed by the supplier is for a short period and early payments. Longer average payment period means longer period of credit given by the suppliers or delayed payments.
4. Net Assets or Capital Turnover Ratio
It expresses the relationship between net sales and capital employed in the business.
Investment (Net Assets) Turnover ratio = Net Sales/Capital Employed
This ratio is analyzed into two turnover ratios:
(a) Fixed Assets Turnover= Net Sales/Net Fixed Assets
(b) Working Capital Turnover = Revenue from operations/Working Capital
Working Capital = Current Assets – Current Liabilities
Current Asset = Current Investments + Inventories (Excluding Spare Parts and Loose Tools) + trade Receivables + Cash and Cash Equivalents + Short Term Loans and Advances + Other Current Assets
Current Liabilities = Short-Term Borrowings + Trade Payables + Other Current Liabilities + Short-term Provisions
Significance:
High turnover ratios indicate efficient utilization of resources resulting in higher liquidity and profitability in the business.