What Are Activity Ratios?

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Investors use financial ratios to determine a company's performance.
Investors use financial ratios to determine a company's performance. (Image: Hemera Technologies/Photos.com/Getty Images)

Ratios are used to analyze financial information of organizations. Activity ratios are one type of financial ratio used to measure how well a company is using its assets. There are several different ratios used that are considered activity ratios, and they are vital for investors and other stakeholders analyzing an organization’s financial health.

Purpose

Activity ratios are used to evaluate how assets are used by an organization. If a company uses its assets wisely, most likely the company’s performance will be more effective. These ratios are used to indicate how fast a company is able to convert its assets into cash. Investors compare these ratios to ratios of other companies within the same industry. It helps them determine the strength of a company compared to other companies. The information used to calculate these ratios is found on the company’s financial statements.

Asset Turnover

One activity ratio is the asset turnover. It is calculated by dividing sales by the average total assets. The asset turnover ratio tells investors how quickly an organization is able to turn an asset into cash. If this ratio is 3, it means that the company is able to turn over its assets three times in one year. Investors prefer higher asset turnover ratios because it shows the liquidity of the company.

Inventory Turnover

Another important activity ratio is the inventory turnover ratio which tells how often an organization can turn inventory into sales. It is calculated by dividing the cost of goods sold by the total inventory. Investors also prefer higher inventory turnover ratios to lower ones. Companies that learn to turn inventory into revenue at a faster pace typically have better cash flows because they are not sitting on inventory that is unsold.

Accounts Receivable Turnover

To calculate the accounts receivable turnover rate, divide net credit sales by the average accounts receivable. This activity ratio tells how efficient a company is at collecting the money its customers owe. Higher ratios usually mean that the company is efficiently collecting the money owed by its customers.

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