Activity Ratios

Activity ratios provide useful insights regarding an organization's ability to leverage existing assets efficiently.

Learning Objective

Calculate activity ratios to determine organizational efficiency

Key Points

Organizations are largely systems of assets that produce outputs. The efficiency of how those assets are used can be measured via activity ratios.
There are a number of different activity ratios commonly used by stakeholders and managers to assess overall organizational efficiency, most importantly asset turnover, inventory turnover, and degree of operating leverage.
Different businesses and industries tend to focus more on some activity ratios than others. Knowing what ratio is relevant based on the operation or process is an important consideration for managerial accountants.
Inventory turnover is highly relevant for industries selling perishable or time sensitive goods. On the other hand, manufacturing facilities tend to be more concerned with fixed asset turnover.

Terms

leverage
To use in such a way to capture maximum value.
perishable
A good that has an expiration date, or can go bad.

Full Text

Why Firms Measure Activity

Activity ratios are essentially indicators of how a given organization leverages their existing assets to generate value. When considering the nature of a business, the general concept is to generate value through utilizing various production processes, employee talent, and intellectual property. Through identifying the profit compared to the investment in these core assets, the overall efficiency of the organization's utilization can be derived.

How to Measure Activity

There are a number of ways to measure activity. Each calculation has different inputs and different implications. Some examples include:

Average collection period - (Accounts Receivable)/(Daily Average Credit Sales)
Degree of Operating Leverage (DOL) - (Percent Change in Net Operating Income)/(Percent Change in Sales)
DSO Ratio - (Accounts Receivable)/(Daily Average Sales)
Average Payment Period - (Accounts Payable)/(Average Daily Credit Purchases)
Asset Turnover - (Net Sales)/(Total Assets)
Stock Turnover Ratio - (Cost of Goods Sold)/(Average Inventory)
Receivables Turnover Ratio - (Net Credit Sales)/(Average Net Receivables)
Inventory Conversion Ratio - (365 Days)/(Inventory Turnover)
Receivables Conversion Period - (Receivables/Net Sales)(365 Days)
Payable Conversion Period - (Receivables/Net Sales)(365 Days)
Cash Conversion Cycle - Inventory Conversion Period + Receivable Conversion Period - Payable Conversion Period

Using Activity Ratios

By tracking these metrics over time, and comparing them to the competition, organizations and stakeholders can gauge their competitiveness and overall capacity to leverage assets in the current industry. Understanding how to use these ratios, and what the implications are, is central to financial and managerial accounting at the strategic level.

For some business, inventory turnover is an incredibly important metric. A business selling farmed produce, for example, must have a highly sophisticated value chain with minimal warehousing and storage. Inventory turnover must be rapid, as the goods being sold are perishable. Fashion industries are similarly reliant on inventory turnover, as the seasonality of both fashion styles and climate create a strong necessity for careful activity management.

For other businesses, asset turnover is a central activity metric. A manufacturing facility producing semiconductors, for example, will invest heavily in the production facility and related equipment. Ensuring maximum production and annual sales contracts is integral to maintaining profitability, and maximizing utilization of those fixed assets will enormously impact profitability.

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