➢ the action of a lever or the mechanical advantage gained by it
➢ POWER, EFFECTIVENESS ➢ trying to gain more political leverage ➢ the use of credit to enhance one's speculative capacity
1. What are Activity Ratios?
An activity ratio is a type of financial metric that indicates how efficiently a company is leveraging the assets on its balance sheet, to generate revenues and cash. Activity ratios help analysts gauge how a company handles inventory management, which is key to its operational fluidity and overall fiscal health. These are usually referred to as turnover ratios and are a significant category of financial metrics used by stakeholders to assess a company's operational effectiveness.
These ratios provide useful information about how well a company uses its assets and resources to produce sales, revenue, and profits.
The Inventory Turnover Ratio is one of the important activity ratios. It measures the frequency with which a company's inventory is sold and replenished over a given period of time, usually a year.
Effective inventory management techniques are characterized by a high inventory
turnover ratio. For instance, a retail business with quick product turnover can maximize revenue by lowering carrying costs and the risk of keeping outdated inventory.
Another crucial activity ratio is the accounts receivable turnover ratio, which provides insight into a business's capacity for timely client payment collection. A higher accounts receivable turnover ratio implies that the business is managing its credit and collection procedures well. In addition to ensuring a sustainable cash flow, this efficiency in recovering unpaid debts lowers the likelihood of bad debts, promoting overall financial stability. 2. Which are major activity ratios?
i. Accounts Receivable Ratio:
Accounts Receivable Turnover Ratio assesses how effectively a business obtains payments from its clients. It displays the number of times the accounts receivable are collected during a given time frame. Accounts Receivable Ratio =Net Credit Sale/Average Accounts Receivable Interpretation: Higher the ratio, more desirable it is. Example: XYZ Corporation offers industrial supplies for sale. Their average accounts receivable for the year is Rs.250,000 and their net credit sales are Rs.15 lacs.
Turnover Ratio for Accounts Receivable = 15,00,000 / 250,000 =6
Conclusion: The accounts receivable turnover ratio for XYZ Corporation is 6, which indicates that they successfully managed their credit by collecting unpaid invoices six times a year on average.
ii. Inventory Turnover Ratio :
Inventory Turnover Ratio gauges how quickly an organization's inventory is used and replaced over a given time frame. It aids in evaluating the effectiveness of inventory control.
Inventory Turnover Ratio = Cost of Goods Sold/ Average inventory
Interpretation: Higher the ratio, more desirable it is. Example: Consider the retail business ABC Goods, which sells consumer goods. ABC's cost of goods sold (COGS) for the year is Rs. 20 lacs, and the average inventory value is Rs. 500,000.
Inventory Turnover Ratio = 20,00,000 / 500,000 = 4.
Conclusion: The inventory turnover ratio for ABC Electronics in this instance is 4, meaning that they sold and replaced their stock four times in one year. This indicates effective inventory control.
iii. Asset Turnover Ratio
Asset Turnover Ratio assesses the efficiency with which a company's total assets are converted into sales revenue. It provides insight into overall asset management effectiveness. The equation is Asset Turnover Ratio = Net Sales/ Average Total Assets
Interpretation: Higher the ratio, more desirable it is.
Example: XYZ Retail, a chain of clothing stores, achieved net sales of Rs. 40 Lacs for the entire year. On their balance sheet, the average total assets are Rs. 2o Lacs.
Asset Turnover Ratio = 40,00,000 / 20,00,000 = 2
Conclusion: The asset turnover ratio for XYZ Retail is 2, indicating that they produced Rs. 2 in sales for every Rs. 1 of average total assets, demonstrating effective asset utilization.
iv. Fixed Assets Turnover Ratio:
Fixed Assets Turnover Ratio focuses on the effectiveness with which a company's long-term or fixed assets (such as property, plant, and equipment) produce revenue. The equation is
Fixed Assets Turnover Ratio = Net Sales/ Average Fixed Assets
Interpretation: Higher the ratio, more desirable it is.
Example: DEF Manufacturing, operating a factory with significant machinery and
equipment, has annual net sales of Rs. 30 Lacs, while their average fixed asset is Rs. 15 lacs.
Fixed Assets Turnover Ratio =30,00,000 / 15,00,000= 2
Conclusion: DEF Manufacturing's fixed assets turnover ratio of 2 shows that their machinery and equipment produced Rs.2 in revenue for every Rs.1 spent on those assets.
3. What are advantages of Activity Ratios?
These ratios provide various benefits when employed in financial analysis and commercial decision-making. The following are some major benefits of employing activity ratios:
1. Efficiency Evaluation: These ratios clearly indicate how well a business uses its resources and assets. They aid in assessing how efficiently a company manages its working capital, inventory, and other assets to produce revenue. 2. Operational Insight: These ratios provide information about a company's day- to-day operations. They help identify areas where efficiency can be improved, leading to cost reductions and increased profitability. Businesses can make informed decisions to enhance their operational effectiveness by analysing these ratios. 3. Comparative Analysis: It can be used to assess a company's performance in relation to industry averages or competitors. This comparative research can reveal areas where a company may be underperforming or surpassing the competition, particularly in terms of asset management. 4. Trend Analysis: Computing activity ratios can help analyse trends over several time periods. For instance, a falling inventory turnover ratio may point to inventory management problems that must be addressed. 5. Risk evaluation: A high percentage of assets held in inventory or accounts receivable may indicate a liquidity risk. Activity ratios, which show how quickly assets can be turned into cash, can be used to evaluate this risk. 6. Credit Evaluation: Creditors and lenders frequently use these ratios to determine a company's creditworthiness. For instance, a high accounts receivable turnover ratio shows consumers pay their invoices on time, lowering the chance of bad debts.
4. What are the Limitations of Activity Ratios?
While activity ratios are a valuable tool for evaluating a company's operational efficiency, it's essential to supplement them with other quantitative and qualitative financial metrics.
To make well-informed financial judgments and assess a company's overall financial
health, one must consider both the limitations of these ratios and the broader business environment.
Below are the limitations of activity ratios:
1. Industry Variability: These ratios can vary significantly between industries
due to differences in business models and operational cycles. What constitutes a "good" ratio in one industry may not apply to another. Comparisons should be made within the same industry or sector for meaningful insights. 2. Absence of Absolute Values: These ratios offer comparative efficiency measurements but no absolute values. They require context and a comparison to industry benchmarks or historical data to interpret them. 3. Data Quality: The accuracy of financial data, such as inventory valuations, accounts receivable amounts, and accounts payable balances, determines how accurate activity ratios are. Ratios might be misinterpreted if the data is inaccurate or out of date. 4. Seasonality: Some businesses experience significant seasonality in their operations. Activity ratios may fluctuate throughout the year, making drawing meaningful conclusions from a single ratio challenging. Seasonal factors must be considered when analysing these ratios. 5. Non-Financial Factors: These ratios concentrate on financial data and may overlook non-financial factors, such as technical improvements, shifts in consumer preferences, or legislative changes, that impact operational efficiency. 6. Inflation Effects: Certain activity ratios, such as inventory turnover, may be susceptible to the effects of inflation, as increased pricing can impact inventory values. Increased pricing can boost ratios without reflecting increased efficiency by increasing the value of inventory and accounts receivable. 7. Use of Average Values: Activity ratios frequently use average values for assets or other components. Although it can smooth out swings, it might not accurately reflect the circumstances at any particular moment. 8. Limited Focus: Activity ratios have a limited scope because they primarily concentrate on specific areas of business operations. They do not give a total view of the general financial well-being or productivity.
Activity Ratios Vs. Profitability Ratios
It is essential to comprehend the distinctions between these two categories of ratios to conduct a thorough examination of a company's financial performance.
While profitability ratios offer information on the company's capacity to make profits, activity ratios concentrate on the effectiveness of asset utilization.
Aspect Activity Ratio Profitability Ratio
Evaluate asset utilization Analyse the financial
Focus and operational performance and overall effectiveness. profitability.
Describe the effectiveness Provide information about
Purpose of your assets and regular revenue growth and financial business activities. stability.
Usually evaluated over Usually evaluated over a
Time Period shorter time periods longer time period.
High ratios indicate
High ratios indicate strong Interpretation effective asset profitability. management. Aspect Activity Ratio Profitability Ratio
Because operations differ Ratios are more uniform
Industry between sectors, ratios can throughout industries, Variability differ dramatically across making comparisons them. simpler.
What is a Profitability Ratio?
Profitability ratios are a class of financial metrics that assess a business’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity. These ratios provide insights into how efficiently a company generates profit and value for shareholders.
1. Gross Margin: This ratio measures the percentage of profit a company makes from its revenue after accounting for the cost of goods sold.
Gross Profit Ratio = Gross Profit/ Turnover
2. Operating/ EBIDT Margin: Operating margin evaluates a company’s
operating efficiency by considering operating income (earnings before interest and taxes) relative to revenue.
Operating Profit Ratio = Operating Income/ Turnover
3. Net Profit Margin: Net profit margin assesses the overall profitability by considering all expenses, including taxes and interest.
Net Profit Ratio = Net Profit/Turnover
These ratios are valuable tools for assessing a company’s current performance compared to its past performance, the performance of other companies in its industry, or the industry average.
Higher ratios are often more favourable, indicating success at converting revenue to profit. However, it’s essential to compare these ratios with industry peers or historical data for a more meaningful analysis. What Is a Solvency Ratio?
A solvency ratio is a key metric used to measure an enterprise’s ability to meet its long-term debt obligations and is used often by prospective business lenders. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long- term liabilities and thus is a measure of its financial health. An unfavourable ratio can indicate some likelihood that a company will default on its debt obligations.
KEY TAKEAWAYS
• A solvency ratio examines a firm's ability to meet its long-term debts and obligations. • The main solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio. • Solvency ratios are often used by prospective lenders when evaluating a company's creditworthiness as well as by potential bond investors. • Solvency ratios and liquidity ratios both measure a company's financial health but solvency ratios have a longer-term outlook than liquidity ratios. • Like other financial ratios, solvency ratios often hold most value when compared over time or against other companies.
Understanding Solvency Ratios
A solvency ratio is one of many metrics used to determine whether a company can stay solvent in the long term. A solvency ratio is a comprehensive measure of solvency, as it measures a firm's actual cash flow, rather than net income, by adding back depreciation and other non-cash expenses to assess a company’s capacity to stay afloat.
It measures this cash flow capacity versus all liabilities, rather than only short-term debt. This way, a solvency ratio assesses a company's long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.
Solvency ratios vary from industry to industry. A company’s solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in isolation.
Types of Solvency Ratios
Interest Coverage Ratio:
The interest coverage ratio is calculated as follows:
Interest Coverage Ratio=EBIT/Interest Expenses
where:
• EBIT = Earnings before interest and taxes
The interest coverage ratio measures how many times a company can cover its current interest payments with its available earnings. In other words, it measures the margin of safety a company has for paying interest on its debt during a given period.
The higher the ratio, the better. If the ratio falls to 1.5 or below, it may indicate that a company will have difficulty meeting the interest on its debts.
Debt-to-Assets Ratio: The debt-to-assets ratio is calculated as follows:
Debt-to-Assets Ratio=Debt/Assets
The debt-to-assets ratio measures a company's total debt to its total assets. It measures a company's leverage and indicates how much of the company is funded by debt versus assets, and therefore, its ability to pay off its debt with its available assets. A higher ratio, especially above 1.0, indicates that a company is significantly funded by debt and may have difficulty meetings its obligations.
Equity Ratio The shareholder equity ratio is calculated as follows:
The equity ratio, or equity-to-assets, shows how much of a company is funded
by equity as opposed to debt. The higher the number, the healthier a company is. The lower the number, the more debt a company has on its books relative to equity.
Debt-to-Equity (D/E) Ratio
The debt-to-equity (D/E) ratio is calculated as follows:
Debt to Equity Ratio= Debt/ Outstanding Equity
The D/E ratio is similar to the debt-to-assets ratio, in that it indicates how a company is funded, in this case, by debt. The higher the ratio, the more debt a company has on its books, meaning the likelihood of default is higher. The ratio looks at how much of the debt can be covered by equity if the company needed to liquidate.
Don't just look at one ratio from one period; most financial ratios are able to tell more of a story when you look at the same ratio over time or look at the same ratio across similar companies.
Solvency Ratios vs. Liquidity Ratios
Solvency ratios and liquidity ratios are similar but have some important differences. Both of these categories of financial ratios will indicate the health of a company. The main difference is that solvency ratios offer a longer-term outlook on a company whereas liquidity ratios focus on the shorter term.
Solvency ratios look at all assets of a company, including long-term debts such as bonds with maturities longer than a year. Liquidity ratios, on the other hand, look at just the most liquid assets, such as cash and marketable securities, and how those can be used to cover upcoming obligations in the near term.
If an investor wants to know whether a company will be able to pay its bills next year, they are often most interested in looking at the liquidity of the company. If a company is illiquid, they won't be able to pay their short-term bills as they come due. On the other hand, investors more interested in a long-term health assessment of a company would want to loop in long-term financial aspects.
Limitations of Solvency Ratios
A company may have a low debt amount, but if its cash management practices are poor and accounts payable are surging as a result its solvency position may not be as solid as would be indicated by measures that include only debt.
It's important to look at a variety of ratios to comprehend the true financial health of a company, as well as understand the reason that a ratio is what it is. Furthermore, a number itself won't give much of an indication. A company needs to be compared to its peers, particularly the strong companies in its industry, to determine if the ratio is an acceptable one or not.
For example, an airline company will have more debt than a technology firm just by the nature of its business. An airline company has to buy planes, pay for hangar space, and buy jet fuel; costs that are significantly more than a technology company will ever have to face.
