Activity ratios are used to determine the efficiency of the organisation in utilising its assets for generating cash and revenue. It is used to check the level of investment made on an asset and the revenue that it is generating. For this reason, the activity ratio is also known as the efficiency ratio or the more popular turnover ratio.
The role of activity ratio or turnover ratio is in the evaluation of the efficiency of a business by careful analysis of the inventories, fixed assets and accounts receivables.
Let us discuss the types of activity ratios.
Types of Activity Ratios
- Stock Turnover ratio or Inventory Turnover Ratio
- Debtors Turnover ratio or Accounts Receivable Turnover Ratio
- Creditors Turnover ratio or Accounts Payable Turnover Ratio
- Working Capital turnover ratio.
- Investment Turnover Ratio
The following are discussed below.
Stock Turnover Ratio
This is one of the most important turnover ratios which highlights the relationship between the inventory or stock in the business and cost of the goods sold. It shows how fast the inventory gets cleared in an accounting period or in other words, the number of times the inventory or the stock gets sold or consumed. For this reason, it is also known as the inventory turnover ratio.
It is calculated by the following formula
Stock Turnover Ratio = Cost of Goods Sold / Average Inventory
A high stock turnover ratio is indicative of fast moving goods in a company while a low stock turnover ratio indicates that goods are not getting sold and are being stored at warehouses for an extended period of time.
Debtor Turnover Ratio
This ratio is an important indicator of a company which shows how well a company is able to provide credit facilities to its customers and at the same time is also able to recover the due amount within the payment period.
It is also known as accounts receivable turnover ratio as the payments for credit sales that will be received in the future are known as accounts receivables.
The formula for calculating Debtor Turnover ratio is
Debtor Turnover Ratio = Credit Sales / Average Debtors
A higher ratio indicates that the credit policy of the company is sound, while a lower ratio shows a weak credit policy.
Creditors Turnover Ratio
Creditors turnover ratio is a measure of the capability of the company to pay off the amount for credit purchases successfully in an accounting period.
It shows the number of times the account payables are cleared by the company in an accounting period. For this reason, it is also known as the Accounts payable turnover ratio.
The formula for calculating creditors turnover ratio is
Creditors Turnover ratio = Net Credit Purchases / Average Creditors
Where average creditors are also known as average accounts payable.
A high ratio is indicative that a company is able to finance all the credit purchases and vice versa.
Working Capital Turnover Ratio
This ratio is helpful in determining the effectiveness with which a company is able to utilise its working capital for generating sales of its goods.
The formula for calculating working capital turnover ratio is
Working capital turnover ratio = Sale or Costs of Goods Sold / Working Capital
If a company has a higher level of working capital it shows that the working capital of the business is utilized properly and on the other hand, a low working capital suggests that business has too many debtors and the inventory is unused.
Investment Turnover Ratio or Net Asset Turnover Ratio
Investment Turnover Ratio is related to the sales taking place in the business and the net assets or the capital employed. It determines the ability of the business to generate sales revenue by the use of net assets of the business. The ratio is calculated using the following formula
Investment Turnover Ratio = Net Sales/ Capital Employed
Importance of Activity Ratios
Activity ratios are very important indicators of the operating efficiency of the business. It also shows the way in which revenue is generated in a company and the way in which the elements of the balance sheet are utilised for managing the business.
This was all about the Activity Ratios. The concept presented in this article will be of great help to the students in developing a good understanding of the Activity or Turnover Ratios. For more such informative articles, stay tuned to BYJU’S.