Saturday, December 4, 2010

Activity Ratios




Activity Ratios or Efficiency Ratios are used to measure the effectiveness of a firm’s use of resources. Good companies would always put their resources to optimum utilization. Better the activity or efficiency ratio, the better it is for the company and it means the company is utilizing its resources properly and effectively.

The ratios that come under this category are:

1. Average Collection Period
2. Degree of Operating Leverage
3. Days Sales Outstanding Ratio
4. Average payment period
5. Asset Turnover Ratio
6. Stock Turnover Ratio
7. Receivables Turnover Ratio

Let us take a look at these ratios in a little bit more details.

Average Collection Period:

Most organizations make sales on credit. They usually deliver goods/services to their customers without taking the payments due immediately. There could be a credit cycle understanding between them and their customers who would make periodic payments for the goods/services rendered to them. This ratio is used to calculate the efficiency with which an organization is able to collect the payments due to them from their customers.

Formula:

ACP = Accounts Receivable / (Annual Credit Sales / 365 days)

Here, only credit sales are taken into consideration. Cash sales that are settled immediately are not considered for this calculation.

Degree of Operating Leverage:

DOL is a ratio that is used to identify the changes in the operating leverage that a company requires with growth in sales and income. As and when a company grows and its sales increases, the operating costs also increase and the operating leverage required by the promoters also changes. This ratio helps us identify that value.

Formula:

DOL = Percentage Change in Net Operating Income / Percentage Change in Sales

Days Sales Outstanding Ratio:

The DSO ratio is a financial ratio that illustrates how well a company’s accounts receivables are being managed. Here accounts receivables refer to the amount of money due to the company for the services/goods provided to its customers.

Formula:

DSO = Accounts Receivable / Average sales per day or

DSO = Accounts Receivable / (Annual Sales / 365)

Average Payment Period:

Average Payment Period is the total opposite of the Average Collection Period. This is the average time taken by the company to pay off its credit purchases.

Formula:

APP = Accounts Payable / (Annual Credit Purchases / 365)

Asset Turnover:

Asset Turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating revenue or income for the company. A higher asset turnover ratio implies that the company is operating efficiently and is able to generate solid revenue income using the assets at their disposal.

Formula:

Asset Turnover = Sales / Average Total Assets

Stock Turnover Ratio:

Also called the Inventory Turnover Ratio, this is a measure of the number of times inventory is sold or used in a time period corresponding to the average inventory held by the company. This ratio can help us determine how efficiently the company is using its inventory (raw materials) to generate revenue and income. i.e., how quickly is the company able to transform the inventory into finished goods that can be sold and generate an income.

A high turnover rate means that the company is utilizing its available inventory effectively but a very high value may cause risks of inadequate inventory levels. Whereas, a low turnover rate means that the company is overstocking or there are deficiencies in the production strategies.

Formula:

STR or ITR = Total cost of goods sold / Average Inventory

Receivables Turnover Ratio:

The Receivables turnover ratio is used to measure the number of times on an average; the receivables are collected during a particular timeframe. A good receivables turnover ratio implies that the company is able to efficiently collect its receivables.

Formula:

RTR = Net Credit Sales / Average Net Receivables

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