Activity Ratios
Key takeaways
- Activity ratios (also called efficiency ratios) measure how effectively a company uses its assets to generate revenue.
- They are most useful for comparing companies within the same industry and for tracking efficiency over time.
- Common activity ratios include accounts receivable turnover, inventory turnover, asset/total‑assets turnover, and return on equity (ROE).
What are activity ratios?
Activity ratios assess a company’s operational efficiency—how well it converts assets (inventory, receivables, fixed assets) into sales and cash. These metrics help identify strengths or weaknesses in working capital management, inventory control, and asset utilization.
Common activity ratios and formulas
-
Accounts receivable turnover
Formula: Net credit sales ÷ Average accounts receivable
Meaning: Measures how quickly the company collects receivables. A higher ratio indicates faster collection; a low ratio suggests collection problems or loose credit policies. -
Inventory (merchandise) turnover
Formula: Cost of goods sold (COGS) ÷ Average inventory
Meaning: Shows how often inventory is sold and replaced during a period. Higher turnover generally implies efficient inventory management; very high turnover may indicate stockouts, while low turnover can signal excess inventory. -
Asset (or total assets) turnover
Formula: Net sales ÷ Average total assets
Meaning: Indicates how efficiently a company uses all its assets to generate sales. Higher values mean more revenue produced per dollar of assets. -
Return on equity (ROE) — included here as a performance link to efficiency
Formula: Net income ÷ Average shareholder equity
Meaning: Measures the return generated on shareholders’ invested capital. While typically categorized as a profitability ratio, ROE is often used alongside activity ratios to connect asset use with returns to equity holders.
How to interpret activity ratios
- Higher ratios generally signal greater efficiency, but “good” levels depend on industry norms.
- Sudden changes can indicate operational shifts: improving ratios may reflect better management or demand; declining ratios may suggest inventory buildup, collection issues, or underutilized assets.
- Use averages (e.g., average receivables, average inventory) to smooth seasonal effects.
When and how to use them
- Compare companies within the same industry for meaningful insight.
- Track a company’s ratios over multiple periods to spot trends.
- Combine activity ratios with profitability and liquidity ratios to get a fuller picture of financial health (e.g., high asset turnover with low profit margins vs. low turnover with high margins).
Limitations
- Accounting policies (inventory methods, revenue recognition) and seasonality can distort comparisons.
- Ratios alone don’t explain causes—follow up with qualitative and operational analysis.
- Cross‑industry comparisons are often misleading because asset intensity and business models differ widely.
Bottom line
Activity ratios are concise, practical indicators of how efficiently a business uses its assets to produce sales and cash. They are most effective when compared to industry peers and trended over time, and when interpreted together with other financial metrics to identify the underlying operational drivers.