What is an activity ratio?
An activity ratio (also called an efficiency ratio) quantifies how well a company uses balance-sheet resources — like receivables, inventory, and assets — to produce sales. These ratios convert account balances into simple measures (turns, days, or dollars of revenue per dollar of asset) that you can compare across peers or over time.
Key definitions (first use of jargon)
– Turnover ratio: a measure expressed as “times per period” showing how often an asset is converted into sales (e.g., inventory turns).
– Accounts receivable (AR): amounts customers owe for goods or services sold on credit.
– Cost of goods sold (COGS): direct costs attributable to producing the goods that were sold.
– Shareholders’ equity: owners’ claim on the company after liabilities are subtracted from assets.
– Days (e.g., days sales outstanding): converts a turnover into calendar days by dividing the period length (usually 365 days) by the turnover.
Common activity ratios, formulas and short interpretation
– Accounts receivable turnover = Credit sales / Average accounts receivable
– High = faster collections; Low = potential collection problems or lenient credit policy.
– Average AR = (Beginning AR + Ending AR) / 2
– Days sales outstanding (DSO) = 365 / AR turnover
– Converts AR turnover into average collection days.
– Inventory turnover = COGS / Average inventory
– High = inventory moves quickly; Low = slow-moving or obsolete stock.
– Days inventory outstanding (DIO) = 365 / Inventory turnover
– Average days inventory sits before sale.
– Asset (or total assets) turnover = Net sales / Average total assets
– Shows revenue generated per dollar of assets; higher = more efficient use of assets.
– Return on equity (ROE) = Net income / Average shareholders’ equity
– Measures return on owners’ invested capital. (Note: dividing net income by number of shares is earnings per share, not ROE.)
When activity ratios are most useful
– Peer comparison within the same industry (because asset needs and turnover norms vary by industry).
– Trend analysis across reporting periods to spot improving or deteriorating operational efficiency.
– Complementing profitability and cash-flow analysis: efficiency tells you whether assets are being used to generate the revenues underlying profit and cash flows.
Short checklist for using activity ratios
1. Use consistent definitions (credit sales vs. total sales; average balances).
2. Compute averages for beginning and ending balances to smooth seasonality.
3. Compare ratios to industry peers and to the company’s historical levels.
4. Convert turnover to days for intuitive interpretation (DSO, DIO).
5. Watch accounting policy differences (inventory method, revenue recognition) that distort comparisons.
6. Pair activity ratios with profitability and cash-flow metrics for a fuller picture.
7. Investigate large changes (e.g., rising inventory with falling turnover) — could signal demand problems or overstocking.
Worked numeric example (step‑by‑step)
Assume a retailer’s annual figures:
– Credit sales = $1,200,000
– Beginning accounts receivable = $80,000; Ending AR = $120,000
– COGS = $700,000
– Beginning inventory = $90,000; Ending inventory = $110,000
– Net sales (total sales) = $1,500,000
– Beginning total assets = $700,000; Ending total assets = $800,000
– Net income = $120,000
– Beginning shareholders’ equity = $580,000; Ending equity = $620,000
Step 1 — Average balances
– Avg AR = (80,000 + 120,000) / 2 = 100,000
– Avg inventory = (90,000 + 110,000) / 2 = 100,000
– Avg assets = (700,000 + 800,000) / 2 = 750,000
– Avg equity = (580,000 + 620,000) / 2 = 600,000
Step 2 — Ratios
– AR turnover = 1,200,000 / 100,000 = 12.0 times per year
– DSO = 365 / 12.0 ≈ 30.4 days (average days to collect)
– Inventory turnover = 700,000 / 100,000 = 7.0 turns per year
– Days inventory outstanding = 365 / 7.0 ≈ 52.1 days
– Asset turnover = 1,500,000 / 750,000 = 2.0 (dollars of sales per dollar of assets)
– ROE = 120,000 / 600,000 = 0.20 = 20%
Interpretation (brief)
– AR turnover of 12 (≈30 days) means customers pay, on average, about a month after sale.
– Inventory turns of 7 (≈52 days) indicates inventory sells in roughly 7–8 weeks.
– Asset turnover of 2.0 means $2 of sales are generated for every $1 of assets.
– ROE of 20% shows solid return on shareholder capital; pair with profit margins to see drivers.
Pitfalls and caveats
– Activity ratios are industry-sensitive; capital-intensive firms naturally have lower asset turnover.
– Using total sales vs. credit sales alters AR turnover — be explicit about which you use.
– Single-period snapshots can mislead; emphasize trends and multiple metrics.
– Accounting choices (FIFO vs. LIFO, revenue recognition) can shift numerator or denominator and distort comparisons.
Further reading (reputable sources)
– Investopedia — Activity Ratios: https://www.investopedia.com/terms/a/activityratio.asp
– U.S. Securities and Exchange Commission — Key Financial Ratios: https://www.sec.gov/fast-answers/answersratiohtm.html
– Corporate Finance Institute — Ratio Analysis Guide: https://corporatefinanceinstitute.com/resources/knowledge/finance/ratio-analysis/
Educational disclaimer
This explainer is for educational purposes only and does not constitute individualized investment advice or recommendations. Always verify numbers from company filings and consult a licensed professional for decisions that affect your finances.