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Understanding activity ratios 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 essential to understand what activity ratios tell you about a company’s performance. Activity ratios are often called efficiency ratios because they measure how efficiently a company manages its assets. Activity indices can be divided into two categories; turnover rates and days available rates.

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 Available = Net Accounts Receivable ÷ X365 Net Sales

Accounts Receivable Days Available (ARDOH) is the average number of days required to convert accounts receivable to cash. Accounts receivable days available measures a company’s ability to collect from its customers. This number should be compared to the credit terms established by the company. 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 mismanagement of accounts receivable. As a general rule, the acceptable upper limit for a company’s average collection period should be 50% more than the established terms. For example, if a company has established terms of 30 days, the upper limit would be 45 days. Anything over 45 days would be cause for concern. If the A/R days available are lower than the stated terms, the company is doing an excellent job of collecting accounts receivable. If the available A/R days are above the stated credit terms, management may need to adjust credit to reduce accounts receivable.

The A/R days available ratio is extremely important because it allows us to put a company’s accounts receivable balance into perspective, from the balance sheet. If a company 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 are way over the credit terms set by the company, we should be asking how much of that $1,000,000 is actually collectible. In this case, you’d like to look at the age of the accounts receivable to determine how much is likely to be uncollectible.

inventory ratios

Inventory Turnover = Cost of Goods Sold ÷ Inventory

Inventory turnover measures how many times, on average, inventory is sold during the year.

Days of inventory on hand = Inventory ÷ Cost of goods sold X 365

Days of inventory on hand measures how many days of inventory a business has on hand at any given time. Inventory days on hand should be compared to prior years to determine trends affecting inventory and the industry average. Too high a number could indicate poor inventory management or an inventor that is obsolete, unsaleable, or expired. For example, if a company’s days of inventory 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 large jump in days of inventory on hand. There can be many likely reasons for the slowdown, such as increased inventory in anticipation of future shortages, obsolete or expired inventory, or poor inventory management. However, if 90 days is the industry average, the jump may not be of much concern. Management would need to be questioned to help understand why the days of inventory 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 accounts payable are paid during the year.

Accounts Payable Days Available = Accounts Payable ÷ Cost of goods sold X 365

Accounts payable days available is the average number of days it takes to pay 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 higher than the terms offered by providers, it may be a cause for concern because providers may require payment on delivery. However, a low number of available days of accounts payable increases the operating cycle and may cause the need for external financing.

operating cycle

Another useful tool to evaluate the efficiency of a company is the calculation of the operating cycle.

Operating Cycle = A/R Available Days + Inventory Available Days – A/P Available Days

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 A/R days available and the inventory days available and subtracting the A/P days available. Simply put, the operating cycle is the amount of time it takes for a company to buy and manufacture goods, pay for the goods, sell the goods, and receive cash for the items sold. If a company experiences an increase in A/R days available or inventory days available, while A/P days available remains constant, its need for external financing will increase.

Understanding activity ratios is essential to assessing a company’s performance and efficiency. It is important to understand how a change in A/R Days On Hand, Inventory Days On Hand, and A/P Days can affect a company’s operating cycle. Business owners, managers, and investors can benefit from a solid understanding of activity rates.

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