Understanding activity indices is a very important tool for evaluating a company’s performance. Whether you are interpreting your company’s financial ratios or evaluating another company, it is essential to understand what activity ratios indicate 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 “draws,” during the fiscal year.
Accounts Receivable Days Available = Net Accounts Receivable ÷ Net Sales X365
Accounts Receivable Days Available (ARDOH) is the average number of days it takes to convert accounts receivable into cash. Days available for accounts receivable measures a company’s ability to collect from its customers. This number should be compared with 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 mismanage accounts receivable. As a general rule of thumb, the acceptable upper limit for a company’s average collection period should be 50% more than stated terms. For example, if a company has established terms of 30 days, the upper limit would be 45 days. Anything longer than 45 days would be cause for concern. If the available A/R days are lower than the stated terms, the company is doing an excellent job of collecting the receivables. If available A/R days are above stated credit terms, management may need to adjust credit to reduce receivables.
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 taking a look at the balance sheet, however, if we find that the days of accounts receivable are well above the company’s established credit terms, we should be asking how much of that $1,000,000 is actually collectible. In this case, you would 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 available = Inventory ÷ Cost of goods sold X 365
Inventory days available measures how many days of inventory a company has available at any given time. Days of inventory available 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 outdated, unsaleable, or expired inventor. For example, if a company’s days of inventory on hand are 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 a major concern. It would be necessary to question management to help understand why the days of inventory available 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 cashed out, 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 a company’s payment pattern. This must be measured against the terms offered to a company by its suppliers. If the number is higher than the terms offered by the providers, it may be cause for concern because the providers may require cash 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 available days of A/R and the available days of inventory and subtracting the available days of A/P. Simply put, the operating cycle is the amount of time it takes for a business 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 remain constant, its need for external financing will increase.
Understanding activity indices is essential to assess a company’s performance and efficiency. It is important to understand how a change in A/R days available, inventory days available, and A/P days can affect a company’s operating cycle. Business owners, managers, and investors can benefit from a solid understanding of activity indices.
