Looking to gain insight into your business’s operational efficiency? Activity ratios can help you do just that, providing visibility of how well your business uses its assets to generate revenue.
These ratios are an important part of financial analysis for all types of businesses – from startups to enterprises – helping them measure everything from how effectively they pay suppliers to their ability to convert inventory into sales.
This KPI glossary entry will give you a clear financial ratio definition for this highly useful financial metric, covering the different types of activity ratio formulas, their benefits and limitations.
We’ll also provide a step-by-step guide on how to calculate these ratios.
Activity ratios help you understand how efficiently your business generates revenue or cash from its assets, resources and capital.
To simplify this financial ratio definition even further, activity ratios measure the operational efficiency of your business.
As you’ll read later in this article, there are a variety of formulas that each provide a different perspective of your operational efficiency.
Some activity ratios measure how quickly you collect customer payments, others how well your business uses its assets, like inventory, equipment or raw materials, to earn revenue.
There are also formulas to work out your business’s ability to meet debt obligations.
Ultimately, activity ratio analysis can help you spot where you can improve your operations, make better use of assets and give you a clearer picture of your business’s financial health.
Before we show you how to calculate activity ratios, let’s first look at why you should do so – which is something many financial ratio definitions fail to mention.
Three of the most important reasons are:
There are a range of activity ratio formulas you can use to measure how efficiently your business utilises specific assets, collects payments or meets debt obligations.
Generally, the higher the ratio, the better your business’s position. Let's look at some of the most widely used ratios.
To work this one out, the formula to use is:
Accounts Payable Turnover Ratio = Total Purchases / Average Accounts Payable
This ratio is a good one to use as it allows you to gauge the ability of your business to pay its creditors.
The formula gives you the average number of times your business settles its accounts payables in a given period.
You can use this one to see how effectively your business collects customer payments. The formula for this activity ratio is:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
What this formula does is tell you the number of times your business can convert its accounts receivables into cash.
This ratio uses the result from the preceding one to tell you exactly how many days it takes your business to collect customer payments.
The activity ratio formula to use is:
Average Collection Period = 365 / Accounts Receivable Turnover Ratio
This ratio measures how well your business uses fixed assets like buildings, vehicles, equipment or land to produce sales.
A low ratio can indicate that your business has too much capital invested in long-term fixed assets, while a high ratio tells you that those assets are being used efficiently.
The fixed asset turnover ratio is calculated as follows:
Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets
The formula for this activity ratio is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
What it tells you is the number of times your inventory is sold and replaced in a given period, with a higher ratio indicating that you’re managing inventory effectively.
Essentially, it lets you know how efficiently your business converts its inventory into sales.
While the preceding two ratios measured how well your business uses specific assets to earn revenue, this one measures the utlisation of all of your assets.
A higher total asset turnover ratio can indicate that your business is using its assets well, while a low ratio can indicate the opposite and or that you have invested too much capital in assets.
How to calculate this activity ratio is shown below:
Total Asset Turnover Ratio = Net Sales / Average Total Assets
Before showing you how to calculate this activity ratio, let’s define what we mean by working capital.
You can calculate your business’s working capital by deducting your current assets from your current liabilities.
This leaves you with the amount of cash, or assets that can be quickly converted into cash, that you can use to pay off short-term debts.
The working capital ratio, meanwhile, helps you to gauge your business’s ability to meet short term debts with its current assets – with a ratio above one indicating you have enough assets to cover your obligations.
To work out this ratio, you’ll need to use the formula.
Working Capital Ratio = Current Assets / Current Liabilities
Now that you’re across the activity financial ratio definition and some of the most widely used formulas, we’ll next step through how to calculate an activity ratio.
For this example, we’ll calculate the accounts payable turnover ratio for the past year.
In case you need to refresh your memory, let’s recap what this ratio measures. It gives you an indication of your business’s capability to pay its suppliers.
To work it out, you’ll need to take a look at your income statement, where you’ll find the amount of purchases your business made on credit over the past year. Let’s use a hypothetical amount for this example – $446,000.
Next, you’ll need to see what your accounts payable balance was both at the start and end of the past year, which you can find in your balance sheet. Once you have those, add them together then divide by two.
For this example, let’s assume your opening accounts payable balance was $76,000 and your closing balance was $54,000.
This means you would calculate:
($76,000 + $54,000) / 2 = $65,000
Finally, you’ll simply need to add your total credit purchases and average accounts payable figures into the formula. To refresh your memory, the formula is:
Accounts Payable Turnover Ratio = Total Purchases / Average Accounts Payable
Accounts Payable Turnover Ratio = $446,000 / $65,000 = 6.86 times
This means your business pays off its accounts payable balance 6.86 times over the course of a year.
Both these sets of ratios are incredibly useful to track the financial health of your business, but they each focus on different aspects of your finances.
The main reason to use the former is to measure how well your business utilises assets to create revenue.
When it comes to profitability ratios, they take a broader look at your finances. These ratios help you to gauge your company’s ability to generate profit not only from assets, but also its sales, operations and equity.
Activity ratios measure operational efficiency, whereas profitability ratios measure your business’s overall financial health and ability to generate profit.
Some examples of profitability ratios include gross profit margin, net profit margin, operating profit margin, cash flow margin, return on assets, and return on equity.
These ratios play an important part in financial profitability analysis for businesses.
There are certain things you need to keep in mind when using these ratios and analysing their results. Let’s look at some of the limitations you need to be aware of:
You have to remember that these ratios are based purely on your business’s past performance, and therefore you can’t extrapolate future performance from them with complete certainty.
However, tracking them over the long-term may help you spot trends to make an educated guess as to future performance.
The insights from these ratios will only be as accurate as the data used to calculate them. It’s therefore critical to ensure your data is accurate so as to not distort the results.
Keep in mind that these ratios are based purely on financial data, which only tell part of the story.
This means that factors like how happy your customers are with your product or service, or the productivity of your staff, aren’t factored into the results.
Another thing to be aware of is that the ratios only tell you about one aspect of your business’s financial health.
Using them alongside other KPIs can help you gain broader insights into the profitability of your business’s assets and its ability to pay debts.
For instance:
What if the cost of your raw materials rose dramatically due to a supply shortage? Or sales plummeted due to a poor economy?
On the other hand, you may have had a sharp increase in sales due to the Christmas period.
All these factors can skew your results, which is why it’s important to track these ratios across multiple periods.
Whether you’re a small growing business or an enterprise, activity ratio analysis is a highly effective tool to see what’s driving or hindering your operational efficiency.
By using the formulas explored in this article, you can gain a picture of how effectively your business is using its assets and capital to generate revenue.
In particular, they can help you:
One way your business can automate tracking financial KPIs with easy-to-use dashboards and reports is by using financial analysis software.
Our cloud-based platform Fathom, for instance, can help simplify KPI tracking with customisable, visually compelling dashboards and reports that allow you to quickly grasp insights.
Fathom also offers advanced financial statement reporting capabilities that allow you to create custom financial statements that feature KPIs.
If you’re new to Fathom, why not try it for yourself? With our free 14-day trial, you can explore its many benefits and features, which also include consolidated reporting and cash flow forecasting.
It is a financial KPI that measures how efficiently your business uses its assets, resources and capital to generate revenue and cash.
These ratios provide insights into operational efficiency and resource management.
They are important because they give you a picture of your business’s operational efficiency.
There are a variety of ratios that provide, each providing a different view of how your business uses its assets and capital.
This includes allowing you to gauge how well your business converts inventory into sales, pays debts or receives payment from customers.
It can help you see which assets or capital are effectively generating revenue, and those that aren’t.
This means you can pinpoint areas of your operations that need improvement, identify assets that may be ineffective or redundant, and those assets that warrant further investment.
Tracking these KPIs over the long term can help you identify patterns, gauge the trajectory of your business’s financial health and compare performance against similar businesses.
These two sets of ratios form an integral part of ratio analysis, and each focus on different aspects of your business’s finances.
Activity ratios help measure your business’s efficiency in utilising its assets or managing its operations.
Meanwhile, profitability ratios help you gauge your business’s ability to generate profit not only from assets, but also its sales, operations and equity.
Kit is the Content Marketing Manager for The Access Group APAC and Fathom. He is a former journalist with extensive experience in content writing and copywriting across various industries, including higher education, not-for-profit, and finance sectors.
