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Activity Ratios: Definition, Formula & Analysis

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  • 0:05 Activity Ratios
  • 0:31 Assets
  • 1:02 Analysis of Ratios
  • 4:04 Lesson Summary
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Lesson Transcript
Instructor: Kimberly Winston
Businesses need to know how soon they can convert their assets into cash. They use activity ratios to figure it out. In this lesson, you'll learn the definition of activity ratio, as well as about some common types.

Activity Ratios

How long would it take you to convert your assets into cash? The answer to this question is especially important for businesses to answer. For example, companies need to know how fast they can access their cash so they can pay their bills. Businesses also need to gauge the efficiency of their business practices, which they can do using activity ratios. Activity ratios are financial analysis tools used to measure a business' ability to convert its assets into cash.

Assets

Anything that a business owns with an economic value can be considered an asset, which are classified as current or fixed. Resources like cash, inventory or accounts receivable are current assets because they can be converted into cash in a short period of time (under one year). Fixed assets take longer to convert into cash. They include resources like equipment or real estate that provide current benefits but will not be converted into cash until some future date (more than a year).

Analysis of Ratios

Image that you own a business that sells playground equipment: Fantasy Playgrounds, Inc. You need to know how soon you can convert your assets into cash so you can pay your bills. There are several activity ratios that can help you find this information, such as inventory turnover, days in inventory and the average collection period. When Fantasy Playgrounds, Inc. needs to know how often during the year it has to replenish its inventory, it uses the following formula:

Inventory turnover = Cost of goods sold (COGS) / Average inventory

Fantasy Playgrounds' COGS is $700,000, while the average inventory for the same period is $70,000. Therefore, the inventory turnover is 10. To see how efficient your company is at inventory turnover, you compare your rate to your competitor: Scary Good Playgrounds. You can also use the inventory turnover ratio to calculate how many days inventory stays on the shelf:

Days in inventory outstanding = 365 / Inventory turnover

Fantasy Playgrounds, Inc. keeps inventory for an average of 36.5 days. So how does knowing the inventory turnover and the days in inventory tell you if you'll be able to pay your electric bill or your employees? Well, let's think about it. You know that if you buy inventory today, within the next 36.5 days, you'll have sold it and either have, or be expecting to have, the cash in hand.

We refer to money that customers owe you as account receivables. The average collection period is used to calculate how soon you receive that money.

Average collection period = Accounts receivable x days (365) / credit sales

Fantasy Playgrounds, Inc. has $250,000 in account receivables for the year and $1,500,000 in sales. The average collection period for its account receivables is: $250,000 x 365 days / $1,500,000 sales, that is 60.8 or 61 days.

Now that you've calculated the activity ratios for Fantasy Playgrounds, Inc., you can determine when or if you are able to pay your bills, and how effective you are at converting your current assets to cash. However, you're not done yet! Earlier I mentioned that assets were either current or fixed. Some companies find it helpful to measure their ability to generate cash with fixed assets.

For instance, Fantasy Playgrounds, Inc. can use the following formula to calculate its fixed asset turnover:

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