Activity Ratios

Activity ratios (a.k.a. efficiency ratios or turnover multiples) measure how well a firm utilizes its assets and liabilities in its operations. Or, in lame terms, how effectively it converts its net assets into profits.

The Balance Sheet

Before we dive into the most important activity ratios, let’s briefly recap the balance sheet’s most important items.

In a nutshell:

  • Total assets provide a rough estimate of a company’s possessions, liquidation value, and size.
  • Total liabilities show what the company owes to suppliers, partners, banks, and authorities; and
  • Equity consists of investments by owners and accumulated business profits.

A company that has many assets would be expected to generate high revenue as a justification for the capital invested in it (see below). If the firm is efficiently run, it would generate profits as well, but the key thing to understand here is that sizeable investment comes with the expectation to attract clients’ money.

You can see an informative dynamic on the featured balance sheet:
1. In 2018, Company 1 increased its long-term debt nearly five-fold and had a sizeable external investment (Additional paid-in capital – APIC).
2. In the same year, its fixed assets doubled and its cash account nearly quadrupled (we do not know the time progression within the year, we can only see beginning and ending amounts).
3. We do not see what revenue it attracted, but the company bore significant losses, which greatly reduced its retained earnings account in 2018.
4. However, over the next 2 years it kept investing its cash, increasing its fixed assets base, paying back its debt and turned very profitable (see 2020’s retained earnings).

How Do We Calculate Activity Ratios?

Most activity ratios take an item from the income statement in their numerator and an item from the balance sheet in their denominator.

The income statement encompasses an entire period, while the balance sheet is only a snapshot at the period’s end, hence best practice dictates taking an average between the start and the end of the period. And by the same logic, the proper way of calculating them is to use average balance sheet items.

Average~Total~Assets{_{2020}}= \frac {Total~Assets{_{2019}}+Total~Assets{_{2020}}}{2}
Start~of~Year~Assets{_{2020}}= End~of~Year~Assets{_{2019}}

This approach kind of “smooths” the outstanding amounts and limits distortions in case of significant fluctuations.

Turnover Multiples

Activity ratios play an important role in assessing the ability of an organization to manage its assets efficiently. As a result, such an analysis identifies potential areas of improvement for a company. To do that, practitioners commonly use several turnover multiples:

  • Asset Turnover
  • Equity Turnover
  • Receivables Turnover
  • Inventory Turnover
  • Payables Turnover

Asset Turnover reflects the company’s overall efficiency by comparing revenue with average total assets. It answers the question: is the company capable of attracting enough customers (revenue) for the amount of capital it employs?

Total~Assets~Turnover= \frac {Revenue}{Average~Total~Assets}

The higher the asset turnover, the more efficiently the company utilizes its asset base. As a rule of thumb, an asset turnover below 1 indicates an overstretched asset base.

One popular iteration of the ratio is to substitute total assets with fixed assets, thus answering the question of whether capital investments are efficient enough:

Fixed~Assets~Turnover= \frac {Revenue}{Average~Fixed~Assets}

Another important multiple is the equity turnover ratio, where the same question is answered in relation to owners’ equity alone. However, the idea behind the equity turnover indicator is to evaluate the efficiency of the company’s management, which cannot be fully appreciated by excluding the company’s liabilities. A high equity turnover ratio may conceal management’s inefficiency of a company that has too many assets and too much debt. So, one must keep vigilant when substituting assets with owners’ equity:

Equity~Turnover= \frac {Revenue}{Average~Total~Equity}

Receivables Turnover, on the other hand, reflects the company’s credit policies. It answers the question: is the company collecting its clients’ dues (revenue) quickly enough? The higher the receivables turnover, the more efficiently the company is turning sales to cash. In practice, this ratio is rarely used as a standalone, but it serves as one of the three pillars that form the net trading cycle of a company.

Receivables~Turnover= \frac {Revenue}{Average~Receivables}

Inventory Turnover is the third widely used efficiency ratio. It measures the efficiency of a company’s inventory management by answering the question: is the company selling its production (inventory) quickly enough? The higher the inventory turnover, the less value the company locks in its warehouses. Again, this ratio is seldom used as a standalone but is another of the three pillars. When combined with receivables, they form the basis of a company’s operating cycle.

Inventory~Turnover= \frac {Cost~of~Goods~Solved (COGS)}{Average~Inventory}

Payables Turnover considers the company’s payment policies to its suppliers. It answers the question: is the company paying its suppliers and creditors quickly enough? The higher the payables turnover, the quicker the company loses its cash to suppliers and creditors. Like the other two, it is also not used often as a standalone and when combined with them, forms the basis of the company’s cash cycle.

Payables~Turnover= \frac {Total~Purchases}{Average~Payables}

A peculiar feature of this ratio is that it uses total purchases in its numerator, which cannot be readily found on a company’s income statement. Direct costs, for instance, include purchases but also salaries; likewise, operating costs include payments to suppliers and payments that cannot be delayed (like salaries). As external analysts would lack the information they need for estimating total purchases, they often substitute it with COGS plus Ending Inventory less Beginning Inventory:

Payables~Turnover= \frac {COGS+Ending~Inventory-Beginning~Inventory}{Average~Payables}

At times, practitioners would use just COGS as a proxy to purchases, simply because it is just as informative as adding and subtracting inventory accounts:

Payables~Turnover= \frac {COGS}{Average~Payables}

While these current assets and liabilities ratios provide some insight into management’s efficiency, they are more often used as a basis for a set of superior metrics that, when combined, form the Net Trading Cycle, or cash conversion cycle.

Cash Conversion Cycle

To obtain the net trading cycle, one needs to understand how long it takes on average for the company to sell its inventory, to receive money from its customers, and to pay its suppliers. The average time this cycle takes is calculated by using three turnover ratios:

  • Days Sales Outstanding (DSO)
  • Days Inventory Outstanding (DIO)
  • Days Payable Outstanding (DPO)

Ultimately, the net trading cycle or cash conversion cycle (CCC) for the company is given by the equation:

Cash~Conversion~Cycle=DSO+DIO-DPO

Days Sales Outstanding (DSO) looks at how long it takes on average for the company to receive cash from its clients. In other words, it estimates the time needed for a firm to turn sales into cash.

It is calculated by reversing the receivables turnover ratio and multiplying it by the number of days within the period under review. To avoid the peculiarities of the modern calendar, analysts usually standardize ― 30 days for a month, 90 days for a quarter, 360 days for a year:

DSO{_{Yr}}=\frac {Average~Receivables}{Revenue} * 360 \qquad or \qquad Receivables~Turnover * \frac {1}{360}

The higher the DSO, the more of a delay there is in the cash receipts, and the more risky the company’s sales are from a liquidity standpoint. This also means that a company will need more funds to grow its sales because it has to somehow pay the bills and salaries that accompany those sales, before its clients do. Put differently, it will need more investment in working capital to grow.

Days Inventory Outstanding (DIO) considers how long it takes on average for the company to sell its products. In simple terms, it measures the time needed for a firm to turn production into sales. It is calculated by reversing the inventory turnover ratio and multiplying it by the number of days within the period under review:

DIO{_{Yr}}=\frac {Average~Inventory}{COGS} * 360 \qquad or \qquad Inventory~Turnover * \frac {1}{360}

The higher the DIO, the more it takes for the company to sell its products and, much like the DSO, the more liquidity and working capital constraints it will face in its growth agenda. In fact, the sum of DSO and DIO gives us the company’s operating cycle.

Days Payables Outstanding (DPO) is the third component of the CCC. At its core, this ratio considers how long it takes on average for the company to pay its suppliers. We calculate it by reversing the payables turnover ratio and multiplying it by the number of days within the period under review:

DPO{_{Yr}}=\frac {Average~Payables}{COGS} * 360 \qquad or \qquad Payables~Turnover * \frac {1}{360}

The higher the DPO, the longer it takes for the company to pay its suppliers. Unlike the other two ratios, a longer time span here works to the firm’s advantage, because it makes it easier to maintain liquidity and allows for more funds to be used in production. DPO is a serious (and free-of-charge) source of working capital, especially for companies that do not depend on their suppliers and thus have more negotiating power than them.

If you want to find out how to calculate these ratios in Excel, take a look at our activity ratios model.