# What is an Activity Ratio?

## What is Activity Ratio?

**Activity ratios** are financial metrics used to assess the efficiency of business organizations by using their assets (e.g., inventory or fixed assets) and converting them into profit and cash. For this, activity ratios are often referred to as **efficiency ratios** or activity efficiency ratios. Activity ratios are important to companies as they allow the tracking of performance and the efficiency of the assets.

An example includes calculating the average collection period, which measures the average period between selling to customers on credit and collecting the payment from the client to assess the credit policy of the company. Another example is checking if a company improved the process of converting its inventory to sales or cash compared to previous years or not. It is also important to understand what an activity ratio is as defined by investors and financial analysts, as it enables them to compare companies that operate in the same industry and select the ones with higher efficiency and invest in them.

## Types of Activity Ratio

Activity ratios are tools that measure the efficiency of companies as they operate with their assets and convert them into sales or cash. Therefore, the efficiency of each type of asset is measured using a specific formula. The next sections will explain the three most used efficiency ratios and provide their corresponding activity ratio formulas.

### Inventory Turnover Ratio

The **inventory turnover ratio** measures the number of times a business organization sold and replaced its inventory in a specific period. For instance, a business manager calculated the value of the inventory turnover ratio of the company over one year and found a value of 3. This means that the company was able to sell and replace its inventory three times during the year.

As a rule of thumb, higher values of the inventory turnover ratio imply more sales and more inventory replacement, which is preferable to business managers, financial analysts, and investors. To calculate the inventory turnover ratio, the following activity ratio formula is used:

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

where the costs of goods sold refer to the direct costs used to produce goods and products to be sold by the company (e.g., raw materials and direct labor), and the average inventory is the sum of the beginning inventory and ending inventory divided by two.

This ratio can also be used to calculate the days in inventory outstanding, which is also called the **days of inventory on hand**. This last ratio calculates the number of days it takes for a company to sell its corresponding inventory balance over one year. For instance, if this ratio equals 40 days, it indicates that it takes the company 40 days to sell its inventory balance. This ratio is calculated using the following formula:

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

### Total Assets Turnover Ratio

The **total asset turnover** ratio measures the ability of a company to convert its assets into revenue. In other words, this ratio evaluates the level of sales and revenue relative to total assets. For instance, a total assets turnover ratio with the value of 0.01 indicates that for each $1 invested in total assets, the company can generate $0.01. This ratio is calculated using the following formula:

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

where the value of average assets equals the beginning assets plus ending assets divided by 2.

### Fixed Assets Turnover Ratio

Concerning the **fixed asset turnover** ratio, it measures the company's efficiency to generate net sales relative to its fixed assets. By definition, fixed assets are assets that are purchased to use in the long-term and are not likely to be converted into cash in less than a year. To calculate this efficiency ratio, the following activity ratio formula is used:

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

where the value of average fixed assets equals the sum of the beginning and ending fixed assets divided by 2. A value of 0.2 in this ratio implies that the company generates $0.20 in net sales for each $1 invested in fixed assets.

## 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.

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#### What is an activity efficiency ratio?

Activity ratios can also be referred to as efficiency ratios or activity efficiency ratios. They are financial metrics that measure the efficiency of a given company to convert its assets into sales or cash.

#### What are examples of activity ratios?

A total asset turnover with a value of 0.1 indicates that for each $1 invested by the company in assets, it generates $0.1 in revenues.

Also, a fixed asset turnover with a value of 0.2 indicates that for each $1 invested in fixed assets, the company generates $0.2.

#### What are the types of activity ratios?

The most commonly used activity ratios are:

- Inventory turnover ratio, which measures the number of time a company sells and replaces its inventory in a specific period.

- Total asset turnover, which measures the efficiency of the company in converting its total assets to revenues.

- Fixed asset turnover, which measures the efficiency of the company in converting its fixed assets into net sales.

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