What You Should Know about Activity Ratios and Penny Stocks - dummies

What You Should Know about Activity Ratios and Penny Stocks

By Peter Leeds

Activity ratios demonstrate the effectiveness of a penny stock company’s operations. The calculations are based on the annual turnover rate of inventory, receivables, payables, and working capital. Generally speaking, the more rapid turnover implies greater efficiency.

The expected rate of turnover depends very much on the kind of business you’re examining. A fast-food company needs a much higher inventory turnover than a high-end automobile manufacturer. When compared to activity ratios from previous quarters and years, or contrasted with the numbers of competitors, you will have a good idea of how efficient a company is with its operations.

For all the activity ratios, you see values for inventory, fixed assets, and accounts receivable, for example. In all cases, for the denominator, it is generally preferable to use average numbers for the year rather than the number most recently reported on the financial statements.

Inventory turnover

Knowing how many times a company turns over its inventory in a year provides excellent insights into the efficiency of a company.

You will get very different inventory turnover calculations depending on the specific industry in which a company is engaged. High-end vehicle retailers may turn over inventory once a year or less, whereas a clothing retailer will want to move out their wares seasonally and so desire an inventory turnover ratio of at least 4.

To generate the inventory turnover ratio, you divide the costs of goods sold by the value of the inventory, as shown here:


Inventory turnover is a good calculation for penny stocks. When a company is in the early stages, you want to see that it is efficiently producing and selling its wares, especially in contrast with competitors.

Receivables turnover

Turnover in receivables demonstrates the number of times accounts receivable are collected per year. Companies must keep on top of collections to remain profitable. Problems arise with account receivable when

  • Too many customers aren’t paying what they owe.

  • Too many customers aren’t paying in a timely manner.

  • A single customer or two owes a significant portion of the accounts receivable. If that account has trouble paying, any company that relies heavily on that customer for accounts receivable will find itself in a cash crunch.

The longer the time frame for receivables to be paid, and the greater amount outstanding, the higher degree of payment risk a company is exposed to.

With penny stocks, you will usually see pretty strong receivables turnover rates, such as at least 4, but depending on the industry, perhaps as high as 6 or better. This demonstrates that the company gets paid for its wares four times or six times over the course of twelve months.

With penny stocks, look for values of at least 4, regardless of their industry.

Here’s how you calculate the ratio:


Payables turnover

Payables turnover is a reflection of how many times the company pays the amounts owed to its suppliers. You generally want payables turnover to be equivalent to receivables turnover, because money brought in as receivables is used to cover the payables.

The company may be experiencing problems when its payables turnover ratio is decreasing. This is especially true when that decrease occurs without a similar drop in its receivables rate. This is sometimes indicative of an inability to pay what it owes.

Penny stocks with very high payables turnover ratios, such as 4 or better, are generally more willing and able to pay their expenses.

Here’s the equation for calculating the payable turnover ratio:


With the payable turnover ratio, higher numbers are better.

Working capital turnover

Working capital is current assets less current liabilities. The working capital turnover ratio illustrates how effectively a company uses its funds. You can generate this ratio by dividing sales by working capital; here’s the equation:


When this rate is 15 or higher, it means that the company is very effectively using its funds to generate revenues. When the value is lower, such as closer to 1, it is operating much less efficiently. For each dollar of working capital, the first company is generating $15 in sales, while the second company is generating $1.

The working capital turnover ratio will vary dramatically among companies and among industry groups. The figure is more important in relation to the specific company itself to provide some clarity about the efficiency of its operations.

Fixed asset turnover

Fixed assets are items such as factories, property, and equipment. These are long-term assets, and generally the company has no intentions of selling them or doing anything other than using them to generate revenues.

Use this equation to calculate the fixed asset turnover ratio:


By dividing sales into the fixed assets to generate this financial ratio, you gain a reflection of how efficiently the company is using its fixed assets to generate revenues. For example, if it has a $10 million factory, you hope that the high-value asset is contributing to its overall sales.

With penny stocks, use this financial ratio to analyze companies that have factories or expensive equipment related to the production of sales. For penny stocks with few fixed assets, or little reliance on them to produce revenue, you may not need to rely on this financial ratio at all.

Total asset turnover

By dividing sales into the total assets of the company, you derive the total asset turnover. This ratio is a reflection of a company’s efficiency in using assets to generate sales. Here’s the equation:


The greater the total sales, and the lower the total assets, the higher the value. Larger numbers for this ratio mean that the company is generating more revenues and doing so from a smaller asset position. In other words, it is operating more effectively.

Because this calculation is based on total assets, which often don’t have much bearing on the survival or short-term operations of the company, total asset turnover isn’t usually an important ratio for analyzing penny stocks.