Understanding activity rates is a very important tool for evaluating a company’s performance. Whether you’re interpreting your company’s financial ratios or evaluating another company, it’s critical to understand what activity ratios indicate about a company’s performance. Activity ratios are often called efficiency ratios because they measure how efficiently the company manages its assets. Activity rates can be divided into two categories; Turnover ratios and day ratios available.
Accounts receivable ratios
Turnover of accounts receivable = Net sales ÷ Net accounts receivable
The accounts receivable turnover ratio measures how many times, on average, accounts receivable are collected in cash, or “shifts,” during the fiscal year.
Days of accounts receivable available = Accounts receivable net ÷ Net sales X 365
Accounts Receivable Available Days (ARDOH) is the average number of days required to convert accounts receivable to cash. Available accounts receivable days measure a business’s ability to collect from its customers. This number should be compared to the credit terms established by the company. By comparing this number with previous years, we can determine if there is an identifiable trend in accounts receivable. An increase in ARDOH could mean that the company has increased credit terms in an attempt to increase sales or mismanage accounts receivable. As a general rule of thumb, the acceptable upper limit for a company’s average collection period should be 50% more than the stated terms. For example, if a company has 30-day terms, the upper limit would be 45 days. Any period longer than 45 days would be cause for concern. If the days of accounts receivable available are lower than the stated terms, the company is doing an excellent job of collecting accounts receivable. If the days of accounts receivable available are above the established credit terms, management may need to adjust the credit to reduce the accounts receivable.
The proportion of days of accounts receivable available is extremely important because it allows us to put the balance of a company’s accounts receivable in perspective, from the balance sheet. If a business has $ 1,000,000 in accounts receivable, that looks good just by looking at the balance sheet, however if we find that the days of accounts receivable available are well above the credit terms set by the company , we should be wondering how much of that $ 1,000,000 is actually collectible. In this case, you’ll want to look at the age of the accounts receivable to determine how much is likely to be uncollectible.
Inventory turnover = cost of goods sold ÷ Inventory
Inventory turnover measures how many times, on average, inventory is sold during the year.
Inventory days available = Inventory ÷ Cost of goods sold X 365
On-hand inventory days measure how many days of inventory a company has at any given time. On-hand inventory days should be compared to previous years to determine trends affecting inventory and the industry average. Too high a number could indicate poor inventory management or an outdated, unsellable, or outdated inventor. For example, if a company’s available inventory days are 70 days in year 1 and it experiences a jump to 90 days in year 2, the company needs to understand why there was a large increase in available inventory days. There can be many likely reasons for the slowdown, such as increased inventory in anticipation of a future shortage, outdated or obsolete inventory, or poor inventory management. However, if 90 days is the industry average, the jump may not be a major cause for concern. It would be necessary to question management to help understand why the days of available inventory changed.
Accounts payable ratios
Turnover of accounts payable = cost of goods sold ÷ Debts to pay
Accounts payable turnover rates measure how many times, on average, accounts receivable are collected in cash, inventory is sold, and accounts payable are paid during the year.
Accounts Payable Days Available = Accounts Payable ÷ Cost of goods sold X 365
Available accounts payable days is the average number of days it takes to pay accounts payable in cash. This relationship gives an idea of the payment pattern of a company. This must be measured against the terms offered to a company by its suppliers. If the number is greater than the terms offered by the providers, it may be a cause for concern because the providers may require cash on delivery. However, a low number of accounts payable days increases the operating cycle and can lead to the need for external financing.
Another useful tool to evaluate the efficiency of a company is to calculate the operating cycle.
Operating Cycle = A / R Days Available + Inventory Days Available – A / P Days Available
It is important to understand the relationship these three ratios have in affecting a company’s cash flow. The operating cycle is determined by adding the available A / R days and the available inventory days and subtracting the available A / P days. Simply put, the operating cycle is the amount of time it takes for a business to buy and manufacture goods, pay for them, sell them, and receive cash for the items sold. If a business experiences an increase in available accounts receivable days or on-hand inventory days, while available accounts receivable days remain constant, its need for external financing will increase.
Understanding activity rates is essential to assessing the performance and efficiency of a business. It is important to understand how a change in available accounts receivable days, on-hand inventory days, and accounts payable days can affect a business’s operating cycle. Business owners, managers, and investors can benefit from a solid understanding of activity rates.