Understanding Activity Ratios in Bookkeeping - dummies

Understanding Activity Ratios in Bookkeeping

By Stephen L. Nelson

Activity ratios provide an indication of how efficiently a firm runs its operations. For example, all other factors being equal, a firm that keeps a very modest amount of inventory is in better shape than a firm that has to keep (store, manage, warehouse, insure, and so forth) a bunch of inventory.

Inventory turnover ratio

The inventory turnover ratio measures how many times in an accounting period the inventory balance sells out. The formula is as follows:

cost of goods sold/average inventory

The inventory turnover period, as you may have noticed, depends on the period measured in the income statement. If the income statement is an annual statement and, therefore, the cost of goods sold amount is an annual cost of goods sold amount, an inventory turnover ratio of 1.2 means that a firm sells 120 percent of its inventory balance in a year.

No guideline exists for inventory turnover ratios. A good inventory turnover ratio depends on what your competitors are doing within your industry.

Days of inventory ratio

The days of inventory ratio resembles the inventory turnover financial ratio; it estimates how many days of inventory a firm is storing. The ratio uses the following formula:

average inventory/annual cost of goods sold/365

As is the case with the inventory turnover ratio, you don’t see generalized rules for what is an acceptable number for days of inventory. The general rule is that you turn around your inventory just as quickly as your competitor does.

Average collection period ratio

The average collection period ratio shows how long it takes for a firm to collect on its receivables. You can think about this ratio as a measure of the quality of a firm’s credit and collection procedures. In other words, this ratio shows how smart a firm is at deciding to whom to extend credit. This ratio also shows how effective a firm is in collecting from customers.

The average collection period ratio formula looks like this:

average accounts receivable/average credit sales per day

The guideline about the average collection period is that it should tie to your payment terms. Your average collection period should show that most of your customers are paying on time.

Fixed asset turnover ratio

The fixed asset turnover ratio quantifies how efficiently a firm employs its fixed assets. Predictably, this financial ratio is most useful when a firm has a lot of fixed assets: real estate, equipment, and so forth.

The fixed asset turnover ratio uses the following formula:

sales/fixed assets

As is the case with many of these financial ratios, no guideline exists that you can use to determine a good fixed asset turnover ratio. You compare your fixed asset turnover ratio with firms of a similar size in your industry.

Total assets turnover ratio

The total assets turnover ratio also measures how efficiently you’re employing your assets. This ratio is probably more appropriate in the situation where a firm doesn’t have a lot of fixed assets, but the firm still wins or loses at the game of business based on how well the firm manages its assets.

The total assets turnover ratio formula is as follows:

sales/total assets

The total assets turnover ratio that you calculate for your business can’t be compared with some external benchmark or standardized rule. You compare your ratio with the same ratio of similarly sized businesses in your industry. Obviously, your main consideration is whether you’re efficiently using your assets to produce sales relative to your competitors. The more sales you can produce with a given level of assets, the better off your business is.