## Activity Ratios - Examples and Formulas

ACTIVITY RATIOS:

The second classification of ratios are known as the Activity Ratios. Activity Ratios indicate how much a company has invested in a particular type of asset (or group of assets), relative to the revenue the asset is producing. The most common activity ratios include; the average collection period and the inventory turnover ratio. Lets look at each separately; beginning with the average collection period ratio.

AVERAGE COLLECTION PERIOD
The average collection period ratio indicates the average length of time (in days) a business must wait before it receives payment from customers who buy merchandise on credit. Below shows how a business would calculate its average collection period ratio.

 Average Collection Period = Accounts Receivable X 360 days Sales

The formula is made up of three components; accounts receivable, sales, and finally 360 days. An account receivable is a promise made by a customer to pay for a product or service at a later point in time. Sales represent a company's total receipts from selling the products or services it offers to customers. In other words, when a company sells products or services to its customers, the company is said to be making sales. The 360 days represent the average number of days a business operates during a normal business year. Below shows the values needed in order to calculate the average collection period ratio for the Widget Manufacturing Company.

 From Balance Sheet From Income Statement CURRENT ASSETS: REVENUE: Cash \$ 2,550 Sales \$112,500 Marketable securities \$ 2,000 Cost of Goods Sold(COGS) \$ 85,040 Account Receivable (Net) \$16,675 Gross Margin \$ 27,460 Inventories \$26,470 Total Current Assets \$47,695

Using the above figures, we can calculate the average collection period ratio for the Widget Manufacturing Company as of December 31, 200Y.

 Average Collection Period = Accounts Receivable X 360 days Sales = \$ 16,675 X 360 \$112,500 = 53.36 or 54 days (rounded up to the nearest day)

Therefore, when a customer buys products on credit from the Widget Manufacturing Company, it will take, on average, 54 days before the company receives cash from the customer. If the company's credit granting policy requires customers to pay within 30 days from the date of purchase, then we can conclude the following;

Customers, on average, are taking 24 extra days to pay for purchases placed on credit (54 days - 30 days = 24 days). In other words, customers are not paying on time.

Note: the lower the average collection period, the faster a company receives its money from customers, and the stronger a company appears. On the other end of the continuum, the higher the average collection period ratio, the longer customers take to pay their bills, and the less stable a company appears.

INVENTORY TURNOVER RATIO:
The second type of activity ratio is known as the Inventory Turnover Ratio. The inventory turnover ratio provides an indication on whether a company has excessive or inadequate goods (products) in inventory. The ratio calculates the number of times per year a company uses or consumes an average stock of goods.

Often businesses have too much inventory on hand in relation to demand. In this instance, a company may experience cash flow problems since they are required to finance the inventory until it's sold and cash is received. Other businesses may have insufficient inventory on hand which may lead to dissatisfied customers and eventual loss of customers due to unfilled orders.

It's your responsibility as a business owner to monitor your inventory levels so that you do not carry too much or too little. You may use the inventory turnover ratio to assist you with this task. Here's how the inventory turnover ratio is calculated.

 Inventory Turnover Cost of Goods Sold Average Inventory * = \$85,040 (\$22,500 + \$26,470) / (2) = 3.5 times

The two items needed to calculate the inventory turnover ratio are sales and average inventory. Cost of Goods Sold, as the name implies, represents the costs incurred on all products sold. Furthermore, a business can only recognize, as an expense, the costs of the products sold. Unsold products are still owned by a business and considered inventory. Average inventory is calculated by adding a company's beginning inventory to its ending inventory and dividing by two (2). Beginning inventory represents the value of the inventory at the start of the business year (January 1, 200Y), while the ending inventory represents the value of the inventory at the end of the business year (December 31, 200Y). In this example, we are assuming the company's beginning inventory on January 1, 200Y is valued at \$22,500 (taken from the Assumptions Section of our example) . The \$26,470 shown on the balance as of December 31, 200Y is considered the company's ending inventory. Below shows the values needed in order to calculate the Inventory turnover ratio for the Widget Manufacturing Company.

 From Balance Sheet From Income Statement CURRENT ASSETS: REVENUE: Cash \$ 2,550 Sales \$112,500 Marketable securities \$ 2,000 Cost of Goods Sold(COGS) \$ 85,040 Account Receivable (Net) \$16,675 Gross Margin \$ 27,460 Inventories \$26,470 Total Current Assets \$47,695

As you can see, inventory appears on the balance sheet, while cost of goods sold appears on a company's income statement. Using the above figures, we can calculate the inventory turnover ratio for the Widget Manufacturing Company as of December 31, 200Y.

 Inventory Turnover Cost of Goods Sold Average Inventory * = \$85,040 (\$22,500 + \$26,470) / (2) = 3.5 times

Therefore, the Widget Manufacturing Company has an Inventory Turnover Ratio of 3.5 times. That is, the company used its inventory 3.5 times during 200Y.

Note: if a company's inventory turnover ratio is too high, it may mean a company is running out of inventory at various times throughout the business year. Also, in many cases, businesses with a high inventory turnover ratio will experience a loss of sales to competitors. On the other hand, the lower an inventory turnover ratio, the less cash required by a company to finance its inventory, and therefore the stronger a company generally appears.

Activity Ratios Summary:
In summary, the activity ratios consist of the average collection period ratio and the inventory turnover ratio. The average collection period ratio is calculated by dividing the accounts receivable by the sales. The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory (IE beginning inventory + ending inventory/2).  Below summarizes the calculation of the average collection period ratio and the inventory turnover ratio for the Widget Manufacturing Company as of December 31, 200Y.

 Average Collection Period = Accounts Receivable X 360 days Sales = \$ 16,675 X 360 \$112,500 = 53.79 days or 54 days Inventory Turnover = Cost of Goods Sold Average Inventory = \$85,040 (\$22,500 + \$26,470) / (2) = 3.5 times

Categories: Financial