What is an Activity Ratio?

How to Improve Activity Ratios?

It is important to note that understanding the formulas is key to understanding how to improve activity ratios. This is because each activity ratio is improved based on the elements directly linked to its formula. For example, the total asset turnover is directly linked to average total assets and total sales. Therefore, it can be enhanced using different strategies.

First, this activity ratio can be improved by increasing revenue. Second, it can be improved by using leasing, which refers to renting an asset with the option to acquire the asset at a low price at the end of the renting contract, rather than purchasing it. Third, the ratio can be improved by selling underused assets. Finally, it can be enhanced by improving the inventory management system.

Lesson Summary

Activity ratios, often referred to as efficiency ratios, are financial metrics that measure the efficiency of companies in using their assets and converting them into sales or cash (e.g., calculating the average collection period of accounts receivables, which refers to the money that customers owe to the company). These ratios are used by companies to keep track of the performance of their processes. For instance, it allows managers to keep track of the average days it takes the company to convert its inventory into sales to identify if the company improved or not. Efficiency ratios are also used by investors and financial analysts to compare companies in the same industry so they can select the most efficient ones for investing purposes. Among the most common activity ratios, there are inventory turnover ratio, days of inventory on hand, total assets turnover, and fixed assets turnover. These activity ratios can be calculated using the following formulas, respectively:

$$Inventory \;turnover \;ratio =\frac{ Cost \;of \;goods \;sold}{Average \;inventory} $$

$$Days \;of \;inventory \;on \;hand =\frac{365}{Inventory \;turnover \;ratio} $$

$$Total \;asset \;turnover=\frac{Total \;sales}{Average\;assets} $$

$$Fixed \;asset \;turnover=\frac{Net\;sales}{Average\;fixed\;assets} $$

Concerning the inventory turnover ratio, it indicates the number of times a company sells and replaces its inventory. This ratio's formula is calculated using the cost of goods sold, which refers to the costs directly linked to the production of the goods to be sold by the company, and the average inventory, which is the sum of the beginning and ending inventory divided by 2. This ratio allows the calculation of the days of inventory on hand, which calculates the number of days it takes the business organization to sell and replace the inventory on hand. The total asset turnover ratio measures the company's ability to generate sales with respect to its total assets. But for the fixed asset turnover ratio, it measures the company's ability to generate net sales with respect to its fixed assets, which are assets purchased for long-term use and can be converted into cash usually only after one year. Lastly, efficiency ratios can be enhanced using different strategies such as enhancing revenue, leasing instead of renting, selling underused assets, and enhancing the inventory management system.