Activity Analysis in Accounting: Definition & Example

Instructor: Bai Charity Pandita

Charity has college degrees in Finance and Management Accounting. She also has an MBA and is currently a university professor, financial advisor and real estate broker.

Understanding financial statements and the stories beyond the numbers are of prime importance in any business. Learn how to analyze a business in terms of its ability to efficiently manage some of its assets in this lesson.

By computing the activity ratios, you can determine figures which can then be used to interpret how the business fares. The interpretation is usually made through comparisons. You compare these figures to a competitor, the entire industry, or to your own firm's past performance. The two former options are called cross-sectional analysis, while the latter is known as time-series analysis.

From this section forward, we will use hypothetical numbers derived from the financial statements of the handbag company Apple Bags, which are summarized in the table provided. In addition, each formula is shown for reference.

Activity Ratios and Formula
activity ratios

Inventory turnover

The first kind of ratio under the activity ratio column is the inventory turnover. Using this ratio, a business will be able to answer how many times the inventory is being replenished in a year.

Using time-series analysis, we can say that the ability of Apple Bags to convert its inventories into sales improved from 4.3 times in 2015 to 5 times in 2016. Although it may seem quite an improvement, a cross-sectional analysis will tell us that Apple Bags is lagging behind the entire industry. Hence, the business should work harder to sell its bags faster than its peers in the industry.

The industry to which the business belongs to is also important in interpreting the ratio. A very low inventory turnover usually means that there is a problem in the ability of the business to sell its products. However, this can be expected for an industry which sells a low number of inventories, like the luxury car industry. A high inventory turnover is generally a good thing except when the reason for the high inventory turnover is because of defects and quality issues.

Average Collection Period

This kind of activity ratio gives us a number of days pertaining to the collection of a firm's accounts receivables. When a customer buys a product on credit instead of cash and promises to pay it in the future, it means that this is an accounts receivable on the part of the firm. Apple Bags improved in the number of days it collects the accounts receivable from 2015 to 2016. However, the firms in the industry collect its receivables on an average of 27 days. Therefore, there is still room for improvement for Apple Bags.

These numbers can actually help the business in evaluating its existing business practices and policies. For instance, if the numbers generated are below the industry average, it may indicate a very efficient collection method for the firm. On the flipside, if the numbers are too high compared to the industry average, it may be a strong indicator of a problem in the collection department of the business. Also, the firm can revisit their existing credit policy and gauge its appropriateness given their customer profiles.

Average Payment Period

Now, this activity ratio is more concerned with the firm's relationship with its suppliers. This time around, it is the firm which does not pay in cash. Instead, it buys on credit and promises to pay the supplier back sometime in the future. By logic, suppliers are most likely to favor firms which pay them faster than the others.

In the case of Apple Bags, it was faster in paying its suppliers in 2015 than in 2016. However, even if it slowed down on its payment, we can still see that it is still at par with the industry average.

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