# Activity Ratios

Activity ratios (also called efficiency ratios and asset-utilization ratios) are financial ratios which measure how successfully a company is utilizing it assets. Important efficiency ratios include total asset turnover ratio, working capital turnover ratio, inventory turnover ratio, receivables turnover ratio, days inventories outstanding, days sales outstanding, operating cycle, etc.

Analysis of how long money is stuck in different assets such as inventories and receivables is important because these assets do not generate any return instead they incur costs such as carrying costs in case of inventories. It is important to quickly sell inventories and collect cash from receivables so that it can be used in making more and more sales. Key to high return for shareholders is to generate more revenue and hence more income for investors by utilizing their investment more efficiently.

The following table shows a list of ratios which can help use analyze how successful a company has been in best utilizing its assets:

Ratio Numerator Denominator
Total asset turnover ratio Revenue Average total assets
Fixed assets turnover ratio Revenue Average fixed assets
Working capital turnover ratio Revenue Average working capital
Inventory turnover ratio COGS Average inventories
Days inventories outstanding Number of days (30 or 365) Inventory turnover ratio
Receivables turnover ratio Revenue Average receivables
Days sales outstanding Number of days (30 or 365) Receivables turnover ratio
Payables turnover ratio Purchases Average account payable
Days payable outstanding Number of days (30 or 365) Payables turnover ratio

Total asset turnover ratio calculates dollars of revenue earned per dollar of total assets. A high asset turnover ratio tells us that the company because the company is generating more sales per dollar of assets investment, it can potentially have higher return on equity (ROE). It is one of the components in DuPont analysis.

Fixed asset turnover ratio calculates revenue earned per dollar of fixed assets i.e. property plant and equipment. A higher ratio is better, but an analyst should look at the ratio of accumulated depreciation to cost to identify if the high ratio is not just due to assets which are nearing their useful lives.

Working capital turnover ratio calculates dollars of revenue generated per dollar of working capital. Working capital equals current assets minus current liabilities. A high ratio is better, but analyst should make sure that the high ratio is not merely due to very poor liquidity position.

Inventory turnover ratio and days inventories outstanding (DIO) (also called days inventory at hand) are ratios which measure how efficiently a company is converting its inventories into receivables. The inventory turnover ratio calculates total inventories sold divided by average balance of inventories. It measures how many times inventories were refreshed. The days inventories sold calculates the number of days it takes a company to sell its inventories on average. For an annual period, DIO equals 365 divided by inventory turnover ratio. A high inventory turnover ratio and a low days inventories outstanding is better.

Receivables turnover ratio and days sales outstanding (DSO) measure how successfully a company collects money from its customers. Receivables turnover ratio calculates how many times a typical customer pays money during a period and days sales outstanding (DSO) tells us how many days it takes a company to collect cash from its receivables. DSO equals number of days in the period (30 for a month and 365 for a year) divided by receivables turnover ratio. A high receivables turnover ratio and a low days sales outstanding is better.

Payables turnover ratio and days payables outstanding (DPO) determine how long it takes a company to pay its creditors. Payables turnover ratio measures how many times a company pays its suppliers in a period. Days payables outstanding is calculated by dividing the number of days in the period by the payables turnover ratio and it shows how many days a company takes in paying its suppliers. A low payables turnover ratio and a high days payables outstanding are better, but we need to make sure that the longer days payable outstanding is not due to any liquidity problem.

The sum of days inventories outstanding (DIO) and days sales outstanding (DSO) is called the operating cycle and operating cycle minus days payables outstanding (DPO) is called net operating cycle (also called cash conversion cycle).

$$\text{Operating Cycle}=\text{DIO}+\text{DSO}$$

$$\text{Net Operating Cycle}\\=\text{DIO}+\text{DSO}-\text{DPO}\\=\text{Operating Cycle}\ -\ \text{DPO}$$

by Obaidullah Jan, ACA, CFA and last modified on

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