Understanding activity ratios is a very important tool for evaluating a company’s performance.
Whether interpreting the financial ratios for your company or evaluating another company, it is essential to understand what the activity ratios indicate about a company’s performance. Activity ratios are frequently referred to as efficiency ratios because they measure how efficiently the company is managing their assets. Activity ratios can be broken down into two categories; turnover ratios and days on hand ratios.
Accounts Receivable Ratios
Accounts Receivable Turnover = Net Sales ÷ Net Accounts Receivable
The accounts receivable turnover ratio measures how many times, on average, accounts receivable are collected in cash, or “turns”, during the fiscal year.
Accounts Receivable Days on Hand = Net Accounts Receivable ÷ Net Sales X 365
Accounts receivable days on hand (ARDOH) is the average number of days required to convert receivables into cash. The accounts receivable days on hand measures the ability of a firm to collect from its customers. This number should be compared to the company’s stated credit terms. By comparing this number to 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 poor accounts receivable management. As a rule of thumb, the upper acceptable limit for a firm’s average collection period should be 50% more than the stated terms. For example, if a company has stated terms of 30 days, the upper limit would be 45 days. Anything longer than 45 days would be cause for concern. If A/R days on hand is lower than the stated terms a company is doing an excellent job of collecting receivables. If A/R days on hand is above the stated credit terms management may need to tighten credit to lower receivables.
The A/R days on hand ratio is extremely important because it allows us to put a company’s accounts receivable balance, from the balance sheet, into perspective. If a company has $1,000,000 in accounts receivable, that my look good just glancing at the balance sheet, however if we discover the A/R days on hand is well above the company’s stated credit terms, we should question how much of that $1,000,000 is really collectible. In this case you would want to see an accounts receivable aging to determine how much is likely uncollectable.
Inventory Turnover = Cost of Goods Sold ÷ Inventory
Inventory turnover measures how many times, on average, inventory is sold during the year.
Inventory Days on Hand = Inventory ÷ Cost of Goods Sold X 365
Inventory days on hand measures how many days of inventory a firm has on hand at any given time. The inventory days on hand should be compared to previous years to determine the trends affecting inventory and the industry average. Too high of a number could indicate poor inventory management or obsolete, unsalable, or stale inventor. For example, if a company’s inventory days on hand is 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 huge jump in inventory days on hand. There may be many likely reasons for the slowdown, such as increased inventory in anticipation of a future shortage, obsolete or stale 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 inventory days on hand changed.
Accounts Payable Ratios
Accounts Payable Turnover = Cost of Goods Sold ÷ Accounts Payable
Accounts payable turnover ratios measure how many times, on average, accounts receivable are collected in cash, inventory is sold, and payables are paid during the year.
Accounts Payable Days on Hand = Accounts Payable ÷ Cost of Goods Sold X 365
Accounts payable days on hand is the average number of days it takes to pay payables in cash. This ratio gives insight into a company’s pattern of payments. This should be measured against the terms offered to a company by its suppliers. If the number is higher than the terms offered by suppliers, it may be a cause for concern because suppliers may require cash on delivery. However, a low accounts payable days on hand increases the operating cycle and can cause a need for outside financing.
Another useful tool in evaluating a company’s efficiency is calculating the operation cycle.
Operating Cycle = A/R Days on Hand + Inventory Days on Hand – A/P Days on Hand
It is important to understand the relationship these three ratios have in affecting the cash flow of a company. The operating cycle is determined by adding the A/R days on hand and inventory days on hand and subtracting the A/P days on hand. Simply put, the operating cycle is the amount of time it takes a company to purchase and manufacture goods, pay for the goods, sell the goods, and receive cash for items sold. If a company experiences an increase to A/R days on hand or inventory days on hand, while A/P days on hand stays constant, they will increase their need for outside financing.
Understanding activity ratios is essential to evaluating a company’s performance and efficiency. It is important to understanding how a change in A/R days on hand, inventory days on hand, and A/P days can effect a company’s operating cycle. Business owners, managers, and investors can all benefit from a solid understanding of activity ratios.