Home » Blogs » Wealth Corner » Financial analysis essentials: A guide to activity ratios

# Financial analysis essentials: A guide to activity ratios

## Activity ratios are financial metrics used to assess a company’s efficiency in using its resources to generate cash and income. Find more!

Activity ratios are vital when conducting a financial analysis to measure the health and performance of an enterprise. These ratios are regarded as vital because they help in appraising the utilisation of resources by an entity.

Additionally, through these rates, you can gain a better understanding of inventory control systems adopted by different companies as well as account receivables management methods, among others.

The article discusses various types and formulas of activity ratios and explores the meaning of activity ratios in the business industry.

## What is the activity ratio?

The effectiveness of the company in making use of its resources to create cash and income is ascertained by activity ratios. It is used to verify both the income an asset is producing and the degree of investment made on it.

Consequently, the activity ratio is also known as the efficiency ratio or the turnover ratio, which is more often used.

## Types of activity ratios

### Inventory turnover ratio

The financial aspect of a business can indicate the efficiency of inventory management by means of the inventory turnover ratio. In other words, this ratio shows how many times a company sells and replaces its stock within twelve months.

Inventory turnover ratio=Cost of goods sold Average inventory

Fast sales and effective management of inventory are indicated by a high ratio of inventory turnover, which in turn means that a company is efficiently dealing with its stock. However, slow inventory turnover ratios could imply either sluggish sales or too much stock on hand; thus, it may lead to capital shortage problems due to obsolescence or higher storage costs.

Example:

These are a few of the financial metrics of SAT Industries Limited for the financial year ended March 31, 2024:

Source: SAT Industries Limited

Inventory turnover ratio=32,270.17(8,513.78+8,884.512) = 32,270.178699.15 = 3.71 days

The inventory turnover ratio of 3.71 indicates that SAT Industries Limited efficiently manages its inventory.

You may also like: Mastering inventory financing: Types, benefits, and drawbacks

### Accounts receivable turnover ratio

To measure the effectiveness with which a company collects debts, one can use the accounts receivable ratio. It shows how often unpaid bills are recovered in an average year.

Accounts receivable turnover ratio = Net credit salesAverage account receivable

High rates indicate that most customers manage to pay their debts, while low rates represent the opposite, meaning they have to ensure timely payments of their expenses. It is observed that companies with a high turnover of accounts receivables perform better compared to those that have a lower turnover

In contrast, firms which experience low rates of turnover tend to find it challenging to collect sales proceeds from customers who were given credit for these sales.

Example:

These are a few of the financial metrics of Wipro Ltd for the financial year ended March 31, 2024:

Source: Wipro Ltd

Accounts receivable turnover ratio = 897,603(863+4,0452) = 897,6032454 = 365.77

The accounts receivable turnover ratio of 365.77 indicates how efficiently Wipro Ltd collects payments from its customers.

### Accounts payable turnover ratio

An accounts payable turnover ratio helps in measuring the efficiency of a business in handling payments for suppliers or vendors. It is a demonstration of how frequently a specific company pays its debts within a certain time period.

Accounts payable turnover ratio = PurchasesAverage accounts payables

A high accounts payable ratio indicates that a company pays its dues more quickly than one with a low AP. Poor AP does not always imply financial difficulties in firms.

Example:

These are a few of the financial metrics of Tata Motors Ltd for the financial year ended March 31, 2024:

Source: Tata Motors Ltd

Accounts payable turnover ratio = 45,467.53(11,961.78+10,794.302) = 45,467.5311378.04 = 4.00

The accounts payable turnover ratio of 4.00 indicates how efficiently Tata Motors Ltd manages its payables.

Further reading: Understanding the P/E ratio

## Bottomline

These activity ratios are important indicators for investors to measure how a company is performing and its financial capability.

It is essential to screen these ratios on a regular basis in order to make appropriate investing, holding assets and divestments for potential strengths and weaknesses that may exist in the company’s operations. The use of activity ratios leads to improved investment decision-making and diversification into a wide range of portfolios.

## FAQs

1. What are the five fundamental ratios?

Ratio analysis, as used by financial analysis, provides information on the profitability, solvency, liquidity, turnover and earnings of a firm, and this is an essential tool. These five types of ratios, profitability, solvency, liquidity, turnover and earnings, do give a comprehensive picture of the performance efficiency and financial health of a company. Ratio analysis helps managers set objectives for planning activities in order to identify strengths and weaknesses so that they are able to make rational decisions based on critical numbers.

1. What is the formula for the operating ratio?

Divide the total operating expenses and cost of goods sold by the net sales to calculate the operating ratio. A vital ratio indicates how much profit a company can make from its revenue. It also helps to compare the operational performance of different companies in the same industry. A lower operating ratio is generally favourable because it implies reasonable expenditure control.

1. What is the PV ratio?

Profit Volume Ratio is an essential financial indicator determining how much a business makes concerning its sales. The profit on total sales receipts of a company divided will yield this expression, whose meaning cannot be misinterpreted concerning how much each unit sold earns for it. PV ratio is expressed as a percentage such that higher percentages indicate more profitability. Thus, management can monitor this rate regularly, identify areas for improvement, optimise their selling policies and ensure competitiveness within their market.

1. What is the gearing ratio?

The level of a company’s gearing ratios can be used to measure its leverage. A firm has employed borrowed money for operating expenses to some extent; when this application level becomes high, it generates over-leverage concerns. The most frequently used measures are debt-to-equity ratio and debt-to-assets ratio. In times of recession, high gearing indicates more liabilities than assets or equity, which can result in financial instability.

1. What is the coverage ratio?

An evaluation factor is a financial statistic that evaluates the viability of an organisation in meeting its monetary claims, such as interest payment on loans and dividends. This proportion is obtained by dividing the income, cash flow, or alternative earnings sources by a company’s financial obligations. A more excellent coverage ratio means enough assets to satisfy the obligations, while a lower one points out increased default risk.