Activity Ratios: Accounts Receivable Turnover, Inventory Turnover, Total Asset Turnover
Activity ratios measure company sales per another asset account—the most common asset accounts used are accounts receivable, inventory, and total assets. Activity ratios measure the efficiency of the company in using its resources. Since most companies invest heavily in accounts receivable or inventory, these accounts are used in the denominator of the most popular activity ratios.
Accounts receivable is the total amount of money due to a company for products or services sold on an open credit account. The accounts receivable turnover shows how quickly a company collects what is owed to it and indicates the liquidity of the receivables.
| Accounts Receivable Turnover | = | Total Credit Sales Accounts Receivable |
Closely related to the accounts receivable turnover rate is the average collection period in days, equal to 365 days divided by the accounts receivable turnover:
| Average Collection Period | = | 365 Days Accounts Receivable Turnover |
Analysts frequently use the average collection period to measure the effectiveness of a company's ability to collect payments from its credit customers. Generally, the average collection period should not exceed the credit terms that the company extends to its customers.
For a company to be profitable, it must be able to manage its inventory, because it is money invested that does not earn a return until the product is sold. A higher inventory turnover ratio indicates more effective cash management and reduces the incidence of inventory obsolescence. The best measure of inventory utilization is the inventory turnover ratio (aka inventory utilization ratio), which is the total annual sales or the cost of goods sold divided by the cost of inventory.
| Inventory Turnover | = | Total Annual Sales or Cost of Goods Sold Inventory Cost |
Using the cost of goods sold in the numerator is a more accurate indicator of inventory turnover, allowing a more direct comparison with other companies, since different companies would have different markups to the sale price, which would overstate the actual inventory turnover.
In seasonal businesses, where the amount of inventory can vary widely throughout the year, the average inventory cost is used in the denominator.
Example 1: Calculating Inventory Turnover
There are 2 companies selling widgets in 2 locations. Big City Widget Seller sells widgets for $4 in its high priced market. Rural Widget Seller sells widgets for$2 in its low priced market. Both companies sell 12,000,000 widgets annually, hold 1,000,000 widgets in inventory, and the cost of goods for the widgets is $1 for both companies.
Using the annual sales for the numerator:
- Big City Widget Seller Inventory Turnover = $4 × 12,000,000 / $1,000,000 = 48
- Rural Widget Seller Inventory Turnover = $2 × 12,000,000 / $1,000,000 = 24
It would seem that Big City Widget Seller has much better inventory management, but using the cost of goods sold would indicate otherwise:
- Big City Widget Seller Inventory Turnover = $12,000,000 / $1,000,000 = 12 = Rural Inventory Turnover
In the above example, which numerator is chosen for the inventory turnover will result in a large difference in ratios. But since the inventory turnover is a measure of how often the inventory has been turned over (hence the name!), only with the cost of goods sold in the numerator will yield the correct turnover rate, and allow direct comparisons among different companies. Since financial ratios are used for the express purpose of comparing different companies, why use annual sales? Because, unfortunately, most major compilers of financial data have used total annual sales, so this is the ratio that is most widely used.
Closely related to inventory turnover is the days in inventory, equal to 365 days divided by the inventory turnover:
| Days in Inventory | = | 365 Days Inventory Turnover |
Example 2: Calculating Days in Inventory
For the 2 companies in Example 1, using inventory turnover based on cost of goods sold:
- Days in Inventory = 365 Days ÷12 ≈ 30 Days
Note that, in this case, using inventory sales will yield not only different results for the 2 widget sellers, but they would both be incorrect:
- Big-City Widget Seller: Days in Inventory = 365 Days ÷ 48 ≈ 8 Days
- Rural Widget Seller: Days in Inventory = 365 Days ÷ 24 ≈ 15 days
The total asset turnover measures the return on each dollar invested in assets and is equal to the net sales, which is total sales minus cash sales minus returns and allowances, divided by the average total assets:
Net Sales = Total Sales – Cash Sales – Returns and Allowances
If there are no pronounced seasonal variations, then average total sales can be calculated by adding the total assets at the beginning of the year to the total assets at year-end, then dividing by 2:
| Average Total Assets | = | Assets at Beginning of Year + Assets at End of Year 2 |
| Total Asset Turnover | = | Net Sales Average Total Assets |
It shows how much revenue is generated for each dollar invested in assets.
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