BAJAJ BROKING
March 17, 2025
9 mins read
Activity ratios are referred to as the key financial metrics that are used to determine the actual efficiency of an organisation. This efficiency is calculated in terms of managing both its assets and liabilities to generate revenue. In simple terms, activity ratios particularly measure how skillfully a business uses its receivables, inventory, and total assets. This helps in getting deep into its operational performance.
Typically, a high ratio and a low ratio indicates different activities. However, these ratios are quite important for analysts, investors, and business owners. Basically, they use this activity ratio to assess the financial health and operational effectiveness of a company.
That being said, let's walk you through the different types of activity ratios, their importance, and their limitations. Having a clear understanding of the ins and outs of what is the activity ratio will help businesses strengthen their financial performance and improve decision-making.
As discussed above, activity ratios are significant for evaluating how efficiently an organisation is managing its assets and liabilities in day-to-day operations. However, there are several types of activity ratios. Consequently, each offers different aspects of a company's efficiency. Here are a few key types:
Inventory Turnover Ratio
First up is the inventory turnover ratio. It helps businesses understand how effectively they are managing their stock. A high inventory turnover suggests a strong inventory management and a strong sale. On the other hand, a low ratio indicates overstocking or sluggish demand. For industries dealing with perishable goods (pharmaceuticals or food), a high turnover is important to prevent all losses due to spoilage.
However, if the turnover is extremely high, it might suggest that the company is not maintaining enough stock. This could potentially lead to missed sales opportunities.
Accounts Receivable Turnover
Next up is accounts receivable turnover ratio. This type shows how fast a company can collect payments from credit sales. A high turnover here suggests a very strong credit policy along with timely collections. This comes down to improved cash flow. However, a low ratio indicates a poor credit policy or slow-paying customers. This leads to cash flow issues.
Typically, businesses need to find a balance here. Having strict credit terms can eventually drive away potential customers. Additionally, lenient terms may increase the overall risk of bad debts.
Accounts Payable Turnover
The accounts payable turnover ratio measures how efficiently a company pays its suppliers. A high ratio here means the business is settling its debts very quickly. This directly leads to improved supplier relationships and better trade terms. On the contrary, a low ratio means cash flow constraints or a strategic decision to delay payments to maximise liquidity.
While delaying payments may help with short-term cash management, excessive delays can damage supplier trust. Additionally, it may also affect future business operations.
Total Asset Turnover
The total asset turnover ratio helps assess how good a company uses its assets to generate revenue. Here, a high ratio denotes that the business is using its assets efficiently. On the other hand, a low ratio suggests underutilisation or inefficiencies in its operations.
It is important to note that the ratio varies across industries here. A capital-intensive industry (manufacturing) naturally has a lower asset turnover compared to a service-based business. Companies that are looking for higher asset turnover often focus on optimising and strengthening their production processes, asset utilisation, and cost control.
Besides helping investors, businesses, and stakeholders evaluate how efficiently a company manages its resources, there are a number of factors why activity ratios matter. Here’s a little more in detail:
Assesses Cash Flow and Liquidity
Activity ratios offer solid insights into a company's capacity to manage its working capital strongly. For example, the accounts receivable turnover ratio shows how quickly a business collects cash from credit sales. This ensures healthy cash flow.
Improves Financial Planning
By tracking activity ratios over time, companies can identify trends, optimise operations, and spot inefficiencies. This helps in setting realistic financial goals along with improving business performance.
Improved Decision Making
Businesses use activity ratios to make informed decisions about credit policies, inventory management, and supplier relationships. A low inventory turnover ratio here may prompt a company to adjust sales strategies or stock levels.
Attracts More Lenders and Investors
Any company that has strong activity ratios displays good financial health and efficient management. This is one of the top reasons why it attracts investors and lenders. They are always looking for stable and profitable businesses.
Checking Industry Standards
Comparing a company's activity ratios with industry averages helps determine its competitive position. In case a company has a lower total asset turnover ratio than its competitors, it may need to improve its asset utilisation.
Evaluates Operational Efficiency
Activity ratios measure how efficiently a company uses its assets and liabilities. High efficiency means cost savings, higher profitability, and better utilisation of resources.
Each activity ratio is calculated differently. This is because they measure different aspects of a company's operational efficiency. Yet again, while each has different formulas, understanding the logic behind these ratios is important. Here’s a brief:
Inventory Turnover Ratio
As discussed, the inventory turnover ratio denotes how quickly a company sells and stocks its inventory. To determine this, companies/businesses track their total cost of goods sold (COGS) over a specific period. Next up, they compare it with the average inventory level. By analysing trends, businesses can adjust their inventory policies. This helps them improve cash flow and avoid stockpiling.
Accounts Receivable Turnover
This ratio assesses how efficiently a company is collecting payments from the customers who purchase on credit. To calculate this, businesses start with monitoring their net credit sales. Next, they compare them with the average accounts receivable balance over time. To maintain liquidity, it is important to make sure the credit cycles are shorter.
Accounts Payable Turnover
As stated earlier, this metric measures how fast an organisation is settling its debts with suppliers. To calculate this, companies track their total supplier purchases and compare them with the average accounts payable amount. Note that striking a perfect balance here (between timely payments and maintaining liquidity) is super important.
Total Asset Turnover
This ratio is all about how effectively a company is using its total assets to generate revenue. Companies determine this by analysing their total sales in relation to their average asset base. Furthermore, reviewing asset productivity regularly helps businesses improve profitability along with operational efficiency.
Understanding activity ratios goes way beyond just calculating them. It is all about how well you can determine what they reveal about a company's operational efficiency. Here's how they are interpreted:
Inventory Turnover Ratio
A high inventory turnover ratio suggests strong sales and effective inventory management. This further means that the company is not overstocking and has a well-functioning supply chain.
However, if the ratio is too high, it may indicate stock shortages. This may eventually lead to missed sales opportunities. On the other hand, a low ratio could mean slow-moving inventory, or weak demand, or excess stock. In short, this could all tie up capital and eventually increase storage costs.
Accounts Receivable Turnover
A high receivables turnover ratio indicates that a company collects all its payments effectively. This reduces the overall risk of bad debts, eventually ensuring a steady cash flow. However, as stated, an excessively high ratio could also mean the company has strict credit policies that may discourage potential customers. A low ratio suggests delayed payments, potential credit risks, or lenient credit terms. In the end, this can lead to liquidity issues.
Accounts Payable Turnover
A high accounts payable turnover ratio shows that a company pays its suppliers quickly. This strengthens supplier relationships and improves credit terms. However, in case it goes too high, it may indicate poor cash retention.
A low ratio, on the other hand, suggests that the company is taking longer to pay its suppliers. This could also indicate cash flow problems. It is important to create a strategy to maximise available funds before settling liabilities.
Total Asset Turnover
A high total asset turnover ratio indicates that a company efficiently uses its assets to generate revenue. This indicates a strong operational performance. A low ratio might suggest underused resources, or the need for better asset management.
While activity ratios do offer excellent insights into a company's operational efficiency, they do not come without certain limitations. Yet again, despite all limitations, activity ratios remain essential for determining the operational performance if used in the right context. Nevertheless, as an investor or an analyst, you must consider factors like:
Seasonal Fluctuations
Businesses having seasonal demand (like holiday sales) may generally show distorted turnover ratios depending on the time of the year when data is analysed. This can make short-term comparisons unreliable.
Industry Variations
Activity ratios vary significantly across different industries. A low turnover ratio may be normal for capital-intensive industries but may be problematic for retail or FMCG businesses. Comparing ratios without knowing the industry context will straightaway lead to misleading conclusions.
Potential for Manipulation
Companies may engage in several tactics like offering deep discounts to boost sales temporarily. Or, they may also delay supplier payments to artificially improve their turnover ratios. This makes financial analysis less reliable.
Exclusion of External Factors
These ratios only denote the internal efficiency. They do not account for any of the external factors like economic downturns, market demand, or any supply chain disruptions that can impact turnover rates.
Limited Standalone Use
This is extremely important. No single ratio can offer a complete picture of a company’s financial health. Activity ratios should always be analysed alongside liquidity, profitability, and leverage ratios for a well-rounded assessment.
Reliance on Historical Data
Activity ratios are calculated using past financial data. Hence, these may not accurately represent future performance, especially in rapidly growing businesses and markets.
Additional Read - Debtors Turnover Ratio
Activity ratios do serve as an important tool for understanding a company's efficiency. However, their real value lies in how exactly they are used. Here, numbers do not alone tell a story but the content matters. A high turnover ratio might signal efficiency, or it also indicates aggressive credit policies that may eventually lead to bad debt. A low ratio might suggest inefficiency, or it could denote a strategic inventory buildup for future demand. The key here is to go beyond the surface. Start analysing the trends, compare the industry benchmarks, and do not skip on considering external factors before making decisions.
For investors, activity ratios help in analysing how well a company uses its assets. For business owners, they highlight areas for operational improvement. Eventually, when combined with other financial metrics, activity ratios offer a clearer picture of financial health. This helps businesses make smarter and better decisions.
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Activity ratios measure how efficiently an organisation/company is using its assets to generate revenue. They help in assessing the operational performance by analysing the turnover rates of receivables, inventory, payables, and total assets.
Activity ratios entirely focus on asset utilisation and efficiency. On the contrary, liquidity ratios assess a company's ability to meet short-term financial obligations. Liquidity ratios measure solvency while activity ratios evaluate operational effectiveness.
Activity ratios offer insights into a company's efficiency in terms of managing resources. Investors use them to determine how well a business is converting its assets into sales, which impacts profitability and long-term financial health. A company with strong activity ratios is often more competitive and financially stable.
The inventory turnover ratio is calculated as COGS (cost of goods sold) divided by average inventory. It denotes how frequently a company sells and replaces its inventory within a given period.
A high accounts receivable turnover suggests that a company collects payments from customers quickly and efficiently. This indicates excellent collections, strong credit policies, and good cash flow management. On the other hand, an extremely high ratio means overly strict credit policies that could also limit sales growth.
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