As the name suggests this group of ratios gives analytical information about entity’s activities and operations. As entity is engaged in numerous activities over the period, understanding the efficiency of such activities is important as they affect entity’s overall profitability and liquidity.
In simple words, these ratios help us understand how management of the entity utilized the resources at its disposal including current assets (working capital) and non-current asset (long term fixed capital). This measurement is done by computing how many times a particular aspect is “turned over” or in other words frequency of activity.
For some aspect entity is better off if rate is high and in some having a low turnover is considered good. However, as mentioned earlier in ratio analysis discussion that ratios are considered as a whole and no ratio is interpreted and comprehended individually.
Following are the activity ratios each one described in words:
- Total asset turnover
- Fixed asset turnover
- Working capital turnover
- Inventory turnover
- Inventory turnover in days
- Trade receivables turnover
- Receivables turnover in days
- Trade payables turnover
- Payables turnover in days
Formulas Activity Ratios
|Total asset turnover||=||Revenue||/||Average total assets|
|Fixed asset turnover||=||Revenue||/||Average fixed assets|
|Working capital turnover||=||Revenue||/||Average working capital|
|Inventory turnover||=||Cost of sales||/||Average inventory|
|Inventory turnover in days||=||Average invntory||/||Cost of Sales||X||Total days|
|Trade receivables turnover||=||Revenue||/||Average receivables|
|Trade receivables turnover in days||=||Average Receivables||/||Revenue||X||Total days|
|Trade payables turnover||=||Purchases||/||Average payables|
|Trade payables turnover in period||=||Average Payables||/||Purchases||X||Total days|
Total days mean total days in a period assumed. For example for a year it can be 360 or 365
Understanding WHY take Average
There are two things to notice in the above ratios:
- All the ratios have average in the denominator
- All the denominators are balance sheet items and all the numerators are income statement items
Activity ratios use information from income statement and statement of financial position to give information for comparison purposes. However, it could have been more reasonable if the nature of numerator and denominator was matching. Reason is that numerator figures are accounted for over the period whereas denominator figures are accounted for at a specific date of the period therefore, combining these two types of figure in one ratio can cause confusion.
To cater if we use average figures of balance sheet items. For example average of inventory at beginning of the period and end of the period. Therefore if averages are taken on annual basis then 2 figures will be used. If semi-annual basis are used then three figures will be used one beginning and two at the end of each half year. Same way if quarterly average is taken then five figures will be considered one at beginning and 4 relating to the end of each quarter.
Though such combinations of figures from different period are meant to iron out the inconsistencies but they come at the cost of relevance. For example if user wants to know receivable turnover by the end of the year, then figures relating to the earlier periods of the year are irrelevant. Such spread of figures from earlier period is only relevant to some extent if intention is to know average receivable turnover during the year.