A common use of financial ratios is when a lender determines the stability and health of your business by looking at your balance sheet. The balance sheet provides a portrait of what your company owns or is owed (assets) and what it owes (liabilities). Bankers will often make financial ratios a part of your business loan agreement. For instance, you may have to keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities. Show But ratios should not be evaluated only when visiting your banker. Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company. Although there are different terms for different ratios, they fall into 4 basic categories. Liquidity ratiosThese measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts, and provide a broad overview of your financial health. The current ratio measures your company's ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it is calculated by dividing your current assets—such as cash, inventory and receivables—by your current liabilities, such as line of credit balance, payables and current portion of long-term debts. The quick ratio measures your ability to access cash quickly to support immediate demands. Also known as the acid test, the quick ratio divides current assets (excluding inventory) by current liabilities (excluding current portion of long-term debts). A ratio of 1.0 or greater is generally acceptable, but this can vary depending on your industry. A comparatively low ratio can mean that your company might have difficulty meeting your obligations and may not be able to take advantage of opportunities that require quick cash. Paying off your liabilities can improve this ratio; you may want to delay purchases or consider long-term borrowing to repay short-term debt. You may also want to review your credit policies with clients and possibly adjust them to collect receivables more quickly. A higher ratio may mean that your capital is being underutilized and could prompt you to invest more of your capital in projects that drive growth, such as innovation, product or service development, R&D or international marketing. But what constitutes a healthy ratio varies from industry to industry. For example, a clothing store will have goods that quickly lose value because of changing fashion trends. Still, these goods are easily liquidated and have high turnover. As a result, small amounts of money continuously come in and go out, and in a worst-case scenario liquidation is relatively simple. This company could easily function with a current ratio close to 1.0. On the other hand, an airplane manufacturer has high-value, non-perishable assets such as work-in-progress inventory, as well as extended receivable terms. Businesses like these need carefully planned payment terms with customers; the current ratio should be much higher to allow for coverage of short-term liabilities. Efficiency ratiosOften measured over a 3- to 5-year period, these give additional insight into areas of your business such as collections, cash flow and operational results. Inventory turnover looks at how long it takes for inventory to be sold and replaced during the year. It is calculated by dividing total purchases by average inventory in a given period. For most inventory-reliant companies, this can be a make-or-break factor for success. After all, the longer the inventory sits on your shelves, the more it costs. Assessing your inventory turnover is important because gross profit is earned each time such turnover occurs. This ratio can enable you to see where you might improve your buying practices and inventory management. For example, you could analyze your purchasing patterns as well as your clients to determine ways to minimize the amount of inventory on hand. You might want to turn some of the obsolete inventory into cash by selling it off at a discount to specific clients. This ratio can also help you see if your levels are too low and you're missing out on sales opportunities. Inventory to net working capital ratio can determine if you have too much of your working capital tied up in inventory. It is calculated by dividing inventory by total current assets. In general, the lower the ratio, the better. Improving this ratio will allow you to invest more working capital in growth-driven projects such as export development, R&D and marketing. Evaluating inventory ratios depends a great deal on your industry and the quality of your inventory. Ask yourself: Are your goods seasonal (such as ski equipment), perishable (food) or prone to becoming obsolete (fashion)? Depending on the answer, these ratios will vary a great deal. Still, regardless of the industry, inventory ratios can you help you improve your business efficiency. Average collection period looks at the average number of days customers take to pay for your products or services. It is calculated by dividing receivables by total sales and multiplying by 365. To improve how quickly you collect payments, you may want to establish clearer credit policies and set collection procedures. For example, to encourage your clients to pay on time, you can give them incentives or discounts. You should also compare your policies to those of your industry to ensure you remain competitive. Profitability ratiosThese ratios are used not only to evaluate the financial viability of your business, but are essential in comparing your business to others in your industry. You can also look for trends in your company by comparing the ratios over a certain number of years. Net profit margin measures how much a company earns (usually after taxes) relative to its sales. A company with a higher profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities. Operating profit margin, also known as coverage ratio, measures earnings before interest and taxes. The results can be quite different from the net profit margin due to the impact of interest and tax expenses. By analyzing this margin, you can better assess your ability to expand your business through additional debt or other investments. Return on assets (ROA) ratio tells how well management is utilizing the company's various resources (assets). It is calculated by dividing net profit (before taxes) by total assets. The number will vary widely across different industries. Capital-intensive industries such as railways will yield a low return on assets, since they need expensive infrastructure to do business. Service-based operations such as consulting firms will have a high ROA, as they require minimal hard assets to operate. Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. It tells the shareholders how much the company is earning for each of their invested dollars. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%. A common analysis tool for profitability ratios is cross-sectional analysis, which compares ratios of several companies from the same industry. For instance, your business may have experienced a downturn in its net profit margin of 10% over the last 3 years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is performing relatively well. Nonetheless, you will still need to analyze the underlying data to establish the cause of the downturn and create solutions for improvement. Leverage ratiosThese ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business. Debt-to-equity and debt-to-asset ratios are used by bankers to see how your assets are financed, whether it comes from creditors or your own investments, for example. In general, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities. Accessing and calculating ratiosTo determine your ratios, you can use a variety of online tools such as BDC's ratio calculators, although your financial advisor, accountant and banker may already have the most currently used ratios on hand. For a fee, industry-standard data is available from a variety of sources, both printed and online, including Dun & Bradstreet's Industry Norms and Key Business Ratios, RMA's Annual Statement Studies and Statistics Canada (search for Financial Performance Indicators for Canadian Business). Industry Canada's SME Benchmarking Tool offers basic financial ratios by industry, based on Statistics Canada small business profiles. Interpreting your ratiosRatios will vary from industry to industry and over time. Interpreting them requires knowledge of your business, your industry and the reasons for fluctuations. In this light, BDC experts offer sound advice, which can help you interpret and improve your financial performance. Beyond the numbersIt's important to keep in mind that ratios are only one way to determine your financial performance. Beyond what industry a company is in, location can also be important. Regional differences in factors such as labor or shipping costs may also affect the result and the significance of a ratio. Sound financial analysis always entails closely examining the data used to establish the ratios as well as assessing the circumstances that generated the results.
Activity ratios help evaluate a business’s operating efficiency by analyzing fixed assets, inventories, and accounts receivables. It expresses a business’s financial health and indicates the utilization of the balance sheet components. The most common types of activity ratios are as follows: –  You are free to use this image on your website, templates, etc, Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: Activity Ratios (wallstreetmojo.com) All these ratios quantify the operations of a business using numbers from the business’s current assetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more or liabilities. Types of Activity Ratios with Formulas & ExamplesVarious activity ratios can be used depending on the type of business and to arrive at decisions. Let us now look at activity ratios with formulas and examples. #1 – Inventory Turnover RatioThis activity ratio formula shows how many times the inventory has been sold out completely in one accounting periodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more for a business that holds inventory. Inventory Turnover Ratio = Cost of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more / Average Cost of Inventory Example:The cost of goods sold for Binge Inc. is $10,000, and the average inventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business.read more cost is $5,000. Therefore, the inventory turnover ratio is calculated as below: – = $10,000 / $5,000 Inventory Turnover Ratio = 2 It means that the inventory has been sold out twice in a fiscal yearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more. In other words, it takes six months for Binge Inc. to sell its entire inventory. Too much cash into inventories is not good for a business. Hence, necessary measures need to be taken to increase the inventory turnover ratio. #2 – Total Assets Turnover RatioThe total assets turnover ratio calculates the net sales compared to its total assets. In other words, it depicts a business’s ability to generate revenue. It helps investors understand the efficiency of companies in generating revenue using their assets. Total Assets Turnover Ratio = Sales / Average Total Assets. Example:PQR Inc. generated revenue of $8 billion at the fiscal year-endFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more. The total assets at the start of the year were $1 billion and, at the end of the year, $2 billion. Average Total Assets = ($1 billion + $2 billion) / 2 = $1.5 billion Total Assets Turnover Ratio is calculated as below = $8000000000 / $1500000000 Total Assets Turnover Ratio = 5.33 A higher total asset turnover ratio depicts the efficient performance of the business. #3 – Fixed Assets Turnover RatioThe fixed assets turnover ratio measures the efficiency of a business in utilizing its fixed assets. It shows how the company uses fixed assets to generate revenue. Unlike the total assets turnover ratio that focuses on the total assets, the fixed assets turnover ratio focuses only on fixed assets of the business being utilized. Therefore, when the fixed assets turnover ratio is declining, it results from over-investment in any fixed assetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more like a plant or equipment, to name a few. Fixed Assets Turnover Ratio = Sales / Average Fixed Assets. Example:Net sales of Sync Inc. for the fiscal year were $73,500. At the beginning of the year, the net fixed assets were $22,500, and after depreciation and the addition of new assets to the business, the fixed assets cost $24,000 at the end of the year. Average Fixed Assets = ($22,500 + $24,000) / 2 Average Fixed Assets= $23,250. Fixed assets turnover ratio is calculated as below: – = $73,500 / $23,250 Fixed Assets Turnover Ratio = 3.16 #4 – Accounts Receivables Turnover RatioThe accounts receivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more turnover ratio depicts how good a business is at giving credit to its customers and collecting debts. For calculating the accounts receivables turnover ratio, only the credit salesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more are considered and not the cash sales. A higher ratio indicates the being paid by the customers on time, which helps to maintain the cash flow and payment of the business’s debts, employee salaries, etc. It is a good sign when the accounts receivables turnover ratio is higher since the debts are being paid on time instead of writing them off. It shows a healthy business model. Account Receivables Turnover Ratio = Net Credit SalesNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read more / Average Accounts Receivables Example:Roots Inc. is a supplier of heavy machinery spare parts. All of its customers are major manufacturers, and all of the transactions are carried out on a credit basis. The net credit sale for Roots Inc. for the year ended was $1 million and the average receivables for the year were $250,000. The accounts receivables turnover ratio can be calculated as below: – = $1,000,000 / $250,000 Account Receivables Turnover Ratio = 4 It means that Roots Inc. can collect its average receivables four times a year. In other words, the average receivables are recovered every quarter. Advantages of Activity Ratios
ConclusionActivity ratio measures how quickly a business can turn its assets into cash or sales and is a good indicator of its run. Management and accounting departmentsThe accounting department looks after preparing financial statements, maintaining a general ledger, paying bills, preparing customer bills, payroll, and more. In other words, they are responsible for managing the overall economic front of the business.read more can use several activity ratios to gauge their efficiency. The most popular ratios are inventory turnover and total assets turnover. It is always recommended to analyze and compare ratios with other businesses in the industry. Recommended ArticlesThis article has been a guide to activity ratios and their definition. Here, we discuss the different activity ratios types and its formula and examples. You can learn more about accounting from the following articles: – |
Activity ratios allow investors to compare the relative efficiencies of similar companies.
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