Activity Ratios Introduction

We refer to the ratios covered in this post as activity ratios. These ratios measure the efficiency with which the company is managing its operating working capital. 

This post is the fourth in a series about financial ratios. We previously explored return on invested capital, return on common equity, and other profitability ratios. To reiterate a point which we stated previously, the ratios presented here are generic ratios and may not be applicable to all businesses. Different industries will require different ratios. However, managers and investors commonly use the activity ratios presented below to help determine the operating health of a business.  

Inventory Ratios 

Certain businesses, such as retailers and manufacturers, operate with a substantial amount of capital tied up in inventory. For these businesses, the efficiency with which the firm manages inventory means the difference between success and failure. 

There are two ratios which indicate how efficiently the firm is managing inventory. The first is inventory turnover. Inventory turnover is the cost of goods sold (COGS) divided by average inventory over the same period. 

Inventory Turnover = COGS ÷ Average Inventory 

The inventory turnover ratio indicates the number of times the firm sells inventory and replaces it during a period. As with all ratios, there is no “right” number. What is important is the trend, the comparison against industry norms, and the specific reason for the improvement or deterioration of the ratio. Generally, a higher turnover ratio indicates efficiency in how the company is managing its inventory, while a lower ratio indicates a degree of inefficiency. 

We can also use the inventory turnover ratio to determine the number of days of inventory held. We refer to this measure as the days sales in inventory. Days sales in inventory (DSI) is the number of days in the period divided by the inventory turnover.  

Days Sales in Inventory (DSI) = Number of Days in Period ÷ Inventory Turnover 

Note that the higher the inventory turnover, the lower the DSI. This indicates that the more the company sells and replaces inventory in a period, the fewer days’ worth of inventory the firm must hold (and the less capital the company has tied up in inventory). 

Trade Receivable Ratios 

Often a company will sell a product or service and allow its customers to pay in the future. This practice is known as “selling on terms.” To record the transaction, the selling firm recognizes the sale and a corresponding asset to recognize the future payment. This corresponding asset is called a trade (or account) receivable.  

For a firm, the greater the level of trade receivables, the greater the amount of funding (in the form of outside capital and retained earnings) needed to support operations. Thus, firms want to collect receivables as quickly as possible. There are two ratios that can help managers and investors determine the efficiency with which a firm is managing its credit sales. The first of these is the receivables turnover ratio. This ratio shows the number of times in a period a firm collects its outstanding receivables. 

Receivables Turnover = Sales on Credit ÷ Average Accounts Receivable 

The second ratio is the days sales in receivables. This ratio shows the average number of days that a receivable is outstanding before the customer pays. The days sales in receivables ratio is derived from the receivables turnover ratio. 

Days Sales in Receivables (DSR) = Number of Days in Period ÷ Receivables Turnover 

The level of industry competition influences a firm’s credit policies. Customers will prefer to pay for products and services as slowly as possible, while firms want to collect payment as quickly as possible. If a firm extends tighter credit than their competitors, customers will eventually flock to those competitors, thus forcing the firm to match the more liberal credit policies. 

Payables Ratios 

Just as a firm sells products on credit, it also purchases goods or services from suppliers and pays for those products at a later date. When the firm purchases from a supplier, the firm recognizes the purchase as inventory or operating expense, with an offsetting liability account recognizing the obligation to pay the supplier. This obligation is called a trade (or account) payable. 

All else equal, a firm wants to pay its vendors as slowly as feasible. The longer a firm can take to pay its suppliers, the greater that firm’s operating cash flow. 

Like the inventory and receivables ratios mentioned above, investors and managers can analyze payables by looking at both turnover and days outstanding. The first ratio, payables turnover, measures the number of times that the firm pays for inventory purchases in a period. 

Payables Turnover = Inventory Purchases ÷ Average Trade Payables 

We can convert the payables turnover ratio into the number of days payable outstanding. This ratio measures the average number of days the firm takes to pay its bills. 

Days Payables Outstanding (DPO) = Number of Days in Period ÷ Payables Turnover 

While firms try to delay payment as far as possible, they must do so without damaging their relationship with suppliers. 

Cash Operating Cycle and Net Cash Operating Cycle 

Firms want to know how long it will take to convert inventory into cash. By summing the days sales in inventory and the days sales in receivables, investors and managers can determine the average number of days between purchasing product and collecting payment. This is known as the firm’s cash operating cycle. 

Cash Operating Cycle = Days Sales in Inventory + Days Sales in Receivables 

Because firms can delay payment to their suppliers, the full cash conversion period must account for the time to pay suppliers. The net cash operating cycle measures the full cash conversion period by subtracting days payables outstanding from the cash operating cycle. 

Net Cash Operating Cycle = Days Sales in Inventory + Days Sales in Receivables – Days Payables Outstanding 

The longer a firm’s net cash operating cycle, the more the firm must rely on outside capital or surplus cash to fund its working capital. 

Some companies, such as retailers and restaurants, may have negative net cash operating cycles. In these instances, the firm’s suppliers are partially financing the firm’s operations. 

These cycles are also known as the cash conversion and net cash conversion cycles. 

Conclusion 

Activity ratios indicate how well a firm is managing its working capital. A firm which manages its working capital well will receive more operating cash flow than a firm which does not.  

We can view the main components of working capital – inventory, trade receivables, and trade payables – in terms of turnover or days outstanding. Turnover ratios give an indication of the speed with which the firm sells inventory, collects receivables, and pays vendors. We can also calculate the days outstanding for each component of working capital – we simply divide the number of days in the period by the turnover ratio. 

We can assemble the days outstanding ratios to calculate a firm’s net cash operating cycle. This cycle indicates the number of days required to convert sales to cash, net of the delayed payments to suppliers. The longer the cycle, the greater the amount the firm has to invest in working capital. 

On a final note, these activity ratios are helpful to investors in determining earnings quality – a concept which refers to the probability of earnings converting into actual cash flow. For all of the benefits of accrual accounting, an unfortunate side effect is that corporate managers can manipulate earnings to their benefit. So, we will see these activity ratios again when we discuss financial statement analysis.