Activity ratios measure the efficiency or effectiveness with which a firm manages its resources. These ratios are also called turnover ratios because they indicate the speed at which assets are converted or turned over in Revenue from operations (sales). These ratios are expressed as ‘times’ and should always be more than one.
Some of the important activity ratios are:
- Inventory turnover ratio (Stock turnover ratio)
- Trade Receivables turnover ratio (Debtors turnover ratio)
- Trade Paybles turnover ratio (Creditors turnover ratio)
- Working capital turnover ratio
1. Inventory Turnover Ratio (Stock Turnover Ratio)
Inventory turnover ratio is a ratio between cost of revenue from operation and the average inventory. Every firm has to maintain a certain level of inventory of finished goods. But the level of inventory should neither be too high nor too low. It evaluates the efficiency with which a firm is able to manage its inventory. This ratio establishes relationship between cost of revenue from operation and average inventory.
The ratio signifies the number of times on an average the inventory or stock is disposed off during the period. The high ratio indicates efficiency and the low ratio indicates inefficiency of stock management.
2. Trade Receivable Turnover Ratio (Debtors Turnover Ratio)
This ratio establishes a relationship between cost of revenue from operations and average trade receivables - average trade debtors and bill receivables. The objective of computing this ratio is to determine the efficiency with which the trade receivables are managed. This ratio is also known as Ratio of Revenue from Operations (Net Sales) to Average Trade Receivables.
Debtors turnover ratio is an indication of the speed with which a company collects its debts. The higher the ratio, the better it is because it indicates that debts are being collected quickly. In general, a high ratio indicates the shorter collection period which implies prompt payment by debtor and a low ratio indicates a longer collection period which implies delayed payment for debtors.
3. Trade Payables Turnover Ratio (Creditors Turnover Ratio)
It is a ratio between net credit purchases and average trade payables - creditors and Bill payables. In the course of business operations, a firm has to make credit purchases. Thus, a supplier of goods will be interested in finding out how much time the firm is likely to take in repaying the trade payables. This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables. This ratio establishes a relationship between credit purchases and average trade payables.
Trade Payables turnover ratio helps in judging the efficiency in getting the benefit of credit purchases offered by suppliers of goods. A high ratio indicates the shorter payment period and a low ratio indicates a longer payment period.
4. Working Capital Turnover Ratio
Working capital of a concern is directly related to revenue from operations (sales). The current assets like debtors, bill receivables, cash, stock etc, change with the increase or decrease in revenue from operations.
Working Capital = Current Assets – Current Liabilities
Working capital turnover ratio indicates the speed at which the working capital is utilized for business operations. It is the velocity of working capital ratio that indicates the number of times the working capital is turned over in the course of a year. This ratio measures the efficiency at which the working capital is being used by a firm. A higher ratio indicates efficient utilization of working capital and a low ratio indicates the working capital is not properly utilized.