Introducing ratio analysis part 2 : Activity ratios
The first post in this series of articles explaining the basic of ratio analysis covered Liquidity and Leverage ratios, it is available here . This post covers Activity ratios which indicate how efficiently the various assets and current liabilities of the organization are being used .The focus is usually on three areas; inventory, accounts receivables and accounts payable.
a) Asset turnover ratio
Asset turnover ratio measures the effectiveness of the organization in utilizing the assets of the organization. It’s defined as
Asset turnover ratio= Net sales/ Total Assets
Various sectors will be having different asset structures, hence it make no sense to compare the asset turnover ratios across industries.
b) Inventory turnover ratio
This ratio measures the number of times a firm sells its inventory in a year. It’s defined as
Inventory turnover ratio = Cost of goods sold/Average inventory over the year
The average inventory during the year is usually calculated by adding together the beginning and ending inventories during the year and dividing it by 2.This ratio also indicates how liquid an asset is inventory of the company. A low value of this ratio indicates that the inventory is an illiquid asset. A higher value for this ratio indicates that the threat of inventory obsolescence will be quite lesser for the firm. The inventory turnover ratio could be used to find out the days inventory the firm is holding.
Days inventory = 365/ Inventory turnover
c) Account receivables turnover ratio
This ratio calculates the number of times a firm collects the average account receivables each year. It’s calculated by
A/R turnover ratio = Net sales/Average accounts receivables
This ratio will be larger for firms that have a larger portion of their sales as cash sales. An approximate indication about the number of days that elapses between sales and receipt of payments from customers could be got from calculating the Days receivables
Days receivables = 365/ Account receivables turnover ratio
A higher days receivables may indicate poor collection efforts by the firm, the firms’ key customers in financial distress or delayed payments by customers.
d) Account payables turnover ratio
This ratio calculates the number of times a firm pays the average account payables each year. It’s calculated as
Account payables turnover ratio= Cost of goods sold/Average accounts payable
Days payables = 365/Account payables turnover ratio
e) Cash cycle
A related efficiency measure is the cash cycle. This could be thought of as the number of days taken to get back the cash once the firm has used cash. It’s calculated by
Cash cycle = Days account receivables+ Days inventory –Days account payables
An efficient firm will try to have a cash cycle as small as possible. Needless to say, cash cycle varies across industries. Most FMCG firms have a cash cycle close to zero or sometimes even negative. This means that they are able to run their day to day operations on the supplier’s money.
Tags: Activity ratios, days inventory, days recievables, Ratio analysis
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