Note on Types of Activity Ratios

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Activity Ratios

Activity ratios measure a firm's ability to convert different accounts like assets, capital and liabilities within its balance sheets into cashor sales. So, activity ratios are the financial tools that are used to measure the ability of a company or firm to convert assets, liabilities and capital accounts to cash or sales. The faster a business is able to convert its assets into cash or sales, the more efficient it runs.


Source: businessjargons.com
Source: businessjargons.com

1. Stock/ Inventory turnover ratio

It is the relationship between the cost of goods sold during the year and the average inventory. It can be calculated as:

Inventory turnover ratio = \(\frac {Cost of goods sold}{Average inventory}\) = … times

When cost of goods sold & average inventory is unavailable,

Inventory turnover ratio = \(\frac {Sales}{Closing inventory}\) = … times

where,

  • Cost of goods sold = Opening stock + Net purchase + Direct expenses + Manufacturing cost – Closing stock
    or
  • Cost of goods sold = Net sales – Gross profit
  • Average inventory = \(\frac {Opening inventory+closing inventory}{2}\)

Further, Inventory turnover ratio can be calculated in other ways too. Such as:

  • Length of inventory cycle = \(\frac {Number of days in a year}{inventory turnover ratio}\)= ..days
  • Length of inventory cycle = \(\frac {365 * inventory stock}{Sales}\)= ..days
  • Length of inventory cycle = \(\frac {inventory stock}{average daily sales}\)= ..days

Illustration:

The followings are the information of ‘Vapp Co’:

Opening stock Rs. 30,000

Closing stock Rs. 45,000

Purchase Rs. 55,000

Carriage inward Rs. 7,000

Sales Rs. 1,80,000

Carriage outward Rs. 5,000

Sales return Rs. 25,000

Number of days in a year 365 days

Required:

(a) Inventory turnover ratio

(b) Length of inventory cycle

Solution:

Here,
Cost of goods sold
= Opening stock + Purchase + Carriage inward – Closing stock
= 30,000 + 55,000 + 7,000 – 45,000
= Rs. 47,000

Average inventory
= \(\frac {Opening inventory+Closing inventory}{2}\)
= \(\frac {30,000+45,000}{2}\)
= Rs. 37,500

Then,

Inventory turnover ratio
= \(\frac {Cost of goods sold}{Average inventory}\)
=\(\frac {47,000}{37,500}\)
= 1.25 times

Also,

Length of inventory cycle
= \(\frac {Number of days in a year}{Inventory turnover ratio}\)
= \(\frac {365}{Current 1.25}\)
= 292 days

2. Debtors turnover ratio

Debtors turnover ratio compares the sales of the uncollected amount from customers with whom goods were sold. This is to ascertain the efficiencyfor debt collection. Also known as receivable turnover ratio, it can be calculated as:

Source: www.kcgjournal.org
Source: www.kcgjournal.org

Debtors turnover ratio = \(\frac {Net credit sales}{Average debtors}\) = … times

When average debtors & credit sales are not available,

Debtors turnover ratio = \(\frac {Total sales}{Closing debtors}\) = … times

where,

  • Net sales = Sales – sales return
  • Net credit sales = Total credit sales – sales return
  • Average debtors = \(\frac {Opening debtors+Closing debtors}{2}\)

Note: Total sales is taken as credit sales if there is no credit sales.

Illustration:

The following figures are given:

Particulars

Opening balance

Closing balance

Debtors …………………………….

Rs. 80,000

Rs. 1,10,000

Account receivable…………..

Rs. 40,000

-

Total sales for the year………………………. Rs. 5,20,000
Sales return……………………………………….. Rs. 20,000

Required: Debtors turnover ratio

Solution:

Here,
Net credit sales:
= Total sales – sales return
= 5,20,000 – 20,000
= Rs. 5,00,000

Average debtors:
= \(\frac {Opening debtors + Closing debtors}{2}\)+ receivable
= \(\frac {80,000+1,10,000}{2}\)+ 40,000
= Rs. 1,35,000

Thus,
Debtors turnover ratio:
= \(\frac {Net credit sales}{Average debtors}\)
=\(\frac {5,00,000}{1,35,000}\)
= 3.7 times

3. Debt/ Average collection period

Also known as Days sales outstanding or Receivable conversion period, it represents the average number of days for the collection of cash from debtors. It can be calculated as follows:

Average collection period = \(\frac {Days/ Week/ Month in a year}{debtors turnover ratio}\)

Average collection period = \(\frac {Debtors (12 months/ 52 weeks/ 365 days)}{credit sales}\)

Average collection period = \(\frac {debtors}{sales per day}\)

Illustration:

Total sales and sales return for the year are Rs. 5,00,000 and Rs. 1,50,000 respectively.
Account receivable:
1st Baisakh…………… Rs. 90,000
31st Chaitra…………… Rs. 50,000

Required:

(a) Debtors turnover ratio

(b) Average collection period

Solution:

Here,
Net credit sales
= Total sales – sales return
= 5,00,000 – 1,50,000
= Rs. 3,50,000

Average debtors
= \(\frac {Opening receivables+Closing receivables}{2}\)
= \(\frac {90,000+50,000}{2}\)
= Rs. 70,000

Then,

Debtors turnover ratio
= \(\frac {Net credit sales}{average debtors}\)
=\(\frac {3,50,000}{70,000}\)
= 5 times

Also,

Average collection period
= \(\frac {Days/ Week/ Month in a year}{debtors turnover ratio}\)
=\(\frac {365}{5}\)
= 73 days

4. Fixed assets turnover ratio

This ratio is the inter relationship between net sales and fixed assets. This ratio determines the efficiency of the utilization of fixed assets. It is computed as:

Fixed assets turnover ratio = \(\frac {net sales}{net fixed assets}\) = … times

where,

Net sales = Total sales – sales return

Net fixed sales = Fixed assets – Accumulated depreciation

Note: Intangible assets such as patents, goodwill, trademark, etc. are included while calculating Net fixed assets whereas fictitious assets are excluded. However, if Net fixed assets is separately given in Balance Sheet, then the Intangible assets are too excluded.

Illustration:

The Balance Sheet of A.R.M.Y Co. is provided below:

Balance Sheet of A.R.M.Y Co.
As on 31st December, 2015

Liabilities

Amount (Rs.)

Assets

Amount (Rs.)

Share capital

P&L a/c

Debentures

Creditors

Accrued expenses

5,00,000

40,000

80,000

25,000

15,000

Goodwill

Stock

Land & building

Preliminary expenses

60,000

50,000

5,00,000

50,000

6,60,000

6,60,000

Cash sales during year……………………………. Rs. 7,00,000

Credit sales during year………………………….. Rs. 3,00,000

Required:

(a) Fixed assets turnover ratio

(b) Inventory turnover ratio

Solution:

Here,
Net sales
= Cash sales + Credit sales
= Rs. (7,00,000 + 3,00,000)
= Rs. 10,00,000

Net fixed assets
= Goodwill + Land & building
= Rs. (60,000 + 5,00,000)
= Rs. 5,60,000

Then,

Fixed assets turnover ratio:
=\(\frac {net sales}{net fixed assets}\)
=\(\frac {10,00,000}{5,60,000}\)
= 1.79 times

Also,

Inventory turnover ratio:
=\(\frac {Sales}{Closing inventory}\)
=\(\frac {10,00,000}{50,000}\)
= 20 times

5. Total assets turnover ratio

Total assets turnover ratio is the ratio that expresses the relation between net sales and total assets, on a given date. This ratio is calculated as:

Total assets turnover ratio = \(\frac {net sales}{total assets}\)= … times

where,

Total assets = Current assets + Fixed assets – Depreciation + Investment + Intangible assets

Illustration:

Calculate Assets turnover ratio from followings:

Particulars

Amount (Rs.)

Total sales ( credit sales included)

Fixed assets

Current assets

Sales return

5,00,000

2,00,000

60,000

1,10,000

Solution:
Net sales
= Sales – sales return
= Rs. (5,00,000 – 1,10,000)
= Rs. 3,90,000

Total assets
= Fixed assets + Current assets
= Rs. (2,00,000 + 60,000)
= Rs. 2,60,000

Hence,
Assets turnover ratio:
=\(\frac {net sales}{total assets}\)
=\(\frac {3,90,000}{2,60,000}\)
= 1.5 times

6. Capital employed turnover ratio

This ratio depicts the inter-relationship between the permanent capital (capital employed) and net sales. It can be computed as:

Capital employed turnover ratio =\(\frac {net sales}{capital employed}\)

Illustration:

Calculate Capital employed turnover ratio:

Liabilities

Amount (Rs.)

Assets

Amount (Rs.)

Share capital

Reserve & Surplus

Debentures

General reserve

Current liabilities

5,00,000

40,000

80,000

25,000

15,000

Fixed assets

Current assets

Preliminary expenses

Investment

60,000

50,000

50,000

5,00,000

6,60,000

6,60,000

Sales…………………… Rs. 10,00,000
Sales return………... Rs. 70,000

Solution:

Here,
Net sales
= Sales – sales return
= Rs. (10,00,000 – 70,000)
= Rs. 9,30,000

Capital employed
= Share capital + Reserve & Surplus + General reserve – Preliminary expenses
= Rs. (5,00,000 + 40,000 + 25,000 – 50,000)
= Rs. 5,15,000

Therefore,
Capital employed turnover ratio:
=\(\frac {net sales}{capital employed}\)
=\(\frac {9,30,000}{5,15,000}\)
= 1.81 times

References:

Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu

  1. Stock/Inventory turnover ratio is the relationship between the cost of goods sold during the year and the average inventory.
  2. Debtors turnover ratio compares the sales of the uncollected amount from customers with whom goods were sold.
  3. Total assets turnover ratio is the ratio that expresses the relation between net sales and total assets on a given date. 
  4. Debtors/ Average collection period  also known as Days sales outstanding or Receivable conversion period, represents the average number of days for the collection of the cash from debtors.
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