Activity Measures Flashcards
What are activity ratios?
Activity ratios measure how quickly the two major noncash assets (A/R & inventory) are converted to cash
Whereas liquidity ratios report condition at a balance sheet date, the activity ratios measure results over a period of time and thus draw information from the firm’s income statement as well
What is the A/R turnover ratio?
A/R turnover measures the efficiency of accounts receivable collection:
= Net credit sales / Average accounts receivable
If a business is highly seasonal, a simple average of beginning and ending balances in inadequate. The monthly balances should be averaged instead
What does a high A/R turnover ratio mean?
A high turnover means that customers are paying their accounts promptly
How can a company’s A/R turnover ratio be increased?
A/R turnover ratio can be increased in the two ways:
Higher sales (since sales is in the numerator of the ratio) without an increase in receivables will result in better turnover
Encouraging customers to pay quickly (thus, lowering the balance in receivables) will result in a higher turnover (since receivables are in the denominator of the ratio)
What is Days’ outstanding in receivables?
Days’ sales outstanding in receivables (also called average collection period) measures the average number of days it takes to collect a receivable:
= Days in year / Accounts receivable turnover
Note: Days’ sales outstanding in receivables can be compared with the firm’s credit terms to determine whether the average customer is paying within the credit period
What is the Inventory turnover ratio?
Inventory turnover measures the efficiency of inventory management:
= COGS / Average inventory
As with receivables turnover, if a business is highly seasonal, a simple average of beginning and ending balances is inadequate. The monthly balances should be averaged instead
Note: The ratio of a firm that uses LIFO may NOT be comparable with that of a firm with a higher inventory valuation
What does a high inventory turnover ratio mean?
A high turnover implies that the firm is NOT carrying excess levels of inventory or inventory that is obsolete
How can a company’s Inventory turnover ratio be increased?
Inventory turnover ratio can be increased in the two ways:
Since COGS is in the numerator, higher sales without an increase in inventory balances will result in better turnover
Keeping inventory levels as low as possible (since inventory is in the denominator of the ratio) results in a higher turnover
How should the ideal level of inventory turnover be determined for a company?
The ideal level for inventory turnover is industry specific with the nature of the inventory items impacting the ideal ratio
For example, spoilage items such as meat and dairy products will mandate a higher turnover ratio than would a natural resources such as gold, silver and coal. Thus, a grocery store should have a much higher inventory turnover ratio than a uranium mine or a jewelry store
What is Days’ sales in inventory ratio?
Days’ sales in inventory measures the efficiency of the company’s inventory management practices:
= Days in year / Inventory turnover
What is Accounts payable turnover?
Accounts payable turnover measures the efficiency with which a firm manages the payment of vendors’ invoices:
= Purchases / Average accounts payable
If a business is highly seasonal, a simple average of beginning and ending balances is inadequate. The monthly balances should be averaged instead
What is Days’ purchases in accounts payable?
Days’ purchases in accounts payable measures the average number of days it takes to settle a payable:
= Days in a year / Accounts payable turnover
The days’ purchases in accounts payable can be compared with the average credit terms offered by a company’s suppliers to determine whether the firm is paying invoices on a timely basis (or too soon)
What is Operating cycle?
A firm’s operating cycle is the amount of time that passes between the acquisition of inventory and the collection of cash on the sale of that inventory:
= Days’ sale in Receivables + Days’ sales in Inventory
What is Cash cycle?
The cash cycle is that portion of the operating cycle that is NOT accounted for by days’ purchases in accounts payable
= Operating cycle - Days’ purchases in payables
This is somewhat counterintuitive because the cash cycle is the portion of the operating cycle when the company does NOT have cash (i.e. when cash is tied up in the form of inventory or accounts receivable)
What is Fixed assets turnover ratio?
The fixed assets turnover ratio measures how efficiently the company is deploying its investment in plant to generate revenues:
= Net sales / Avg. net PP&E
This ratio is largely affected by the capital intensiveness of the company and its industry, by the age of assets and depreciation method used
A high turnover is preferable to a low turnover
