Facts About Activity Ratios
As a business owner, do you know that you can make use of activity ratios to understand the financial position of your company other than hiring an accounting service in Johor Bahru to help you generate vital financial statements? These ratios can help measure how efficient your company is handling and utilising its resources to maximise its revenue (Also see Are Revenue and Profit the Same?). Some would call these ratios the performance ratios or the asset management ratios.
There are a few activity ratios that help in revealing the ability of the company in converting the components in its balance sheet (for instance, assets and capital) into sales or cash. The first one that we will discuss here is the asset turnover ratio. This ratio measures how efficient a business is in using all the assets it has to make sales. To calculate this ratio, one should divide sales with the company’s average total assets. The higher the asset turnover ratio, the better the company’s performance is. Typically, business owners or the management will calculate this ratio when a financial year comes to an end.
The next ratio is the inventory turnover ratio, which serves as a measure that shows the efficiency of a business in managing its inventories. This ratio presents the company’s ability in managing its inventory levels and the frequency of replenishing them. One need to divide the cost of goods sold (COGS) (Also see Introduction to Finished Goods) with average inventories to arrive at the inventory turnover ratio. If the value of this ratio is high, it is a good sign as this means that there is a high demand in a particular product or services. This can be a sign of having excellent inventory management as well.
Besides, there is an activity ratio which measures how efficient the business is using its assets (Also see Accounting for Intangible Asset), which is the accounts receivable turnover ratio. This ratio also shows the efficiency of a business in collecting credits that it has issued to its clients. If one wants to calculate this ratio, the first step is to work out the average accounts receivable by adding up the values of accounts receivable at the beginning and the end of an accounting period and divide the sum by two. Then, divide the net credit sales in that period by the average accounts receivable.
If the accounts receivable turnover ratio has a high value, this means that the customers are paying their debts quickly. In contrast, a low value is a sign of poor credit policy and inefficient cash collecting process. This ratio helps business owners to evaluate the credit policies of a business as they can determine whether the policies are helpful or harmful for the company.
The last activity ratio that we are going to discuss here is the working capital ratio. This ratio indicates how effective the business is using its working capital. This helps business owners to know the net annual sales that the average amount of working capital has generated in a certain accounting period. Before one calculates this ratio, he needs to obtain the sum of working capital by deducting current liabilities from the company’s current assets. After that, he should divide net sales with working capital to arrive at the ratio. Having a high working capital ratio is a good sign, as this indicates that the company is using its current assets and liabilities effectively to support its sales.
The activity ratios discussed above can provide the business owners with some insights into the efficiency of their business operations. Thus, if they have encountered some problems when they run their business, they can utilise these ratios to determine the issues and fix them with suitable solutions.