Activity ratios measure a business’s ability to turn assets into cash or revenue, including the asset turnover ratio, inventory turnover ratio, and accounts receivable turnover ratio. These ratios are used in fundamental analysis to compare a company’s strength to its competitors within the same industry.
An activity ratio is one of several accounting ratios that measure how quickly a business can turn certain assets into cash or revenue. Three commonly evaluated activity ratios are the asset turnover ratio, the inventory turnover ratio, and the accounts receivable turnover ratio. An activity ratio, along with other accounting ratios, is used in fundamental analysis to determine a company’s relative strength compared to its competitors. The information used to calculate an activity index is found on a company’s balance sheet or income statement.
The asset turnover ratio indicates how quickly, on average, a company can turn an asset into cash. The asset turnover ratio is calculated by dividing sales by average total assets. If annual sales are $1 million US dollars (USD) and average assets throughout the year are $500,000 USD, the asset turnover ratio is 2. This means that the company turns over its assets twice a year . A better asset turnover ratio is better, because it means the company turns over its assets more frequently, so it’s turning assets into sales more quickly.
The inventory turnover ratio indicates how often the company turns its inventory into revenue. Again, a higher ratio is better because it indicates that the company is moving the product quickly from its warehouse to stores and ultimately into the hands of consumers. Analysts can determine the inventory turnover ratio by dividing sales by average inventory.
A company’s efficiency in collecting money owed from customers is measured by the accounts receivable turnover ratio, sometimes referred to as the accounts receivable turnover ratio. To determine this ratio, analysts divide net credit sales by average accounts receivable. A low ratio may mean that the business is having trouble charging its customers. A company that does most or all of its business in cash will have a very high accounts receivable turnover ratio.
As with all accounting indices used in fundamental analysis, it is important to compare any activity indices between companies within the same industry. Typically, some industries will have much lower ratios than others, so comparing companies across industries will typically produce irrelevant data. For example, an activity ratio for a manufacturing company will generally be much lower than the same activity ratio for a fast food company. For the comparison of an activity relationship between two or more companies to be useful, the companies must be in the same industry.
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