What are activity ratios and their importance

Measuring the financial performance of institutions represents a decisive factor in determining the extent of success and sustainability of business activity. Financial ratios, such as liquidity and leverage ratios, are among the most important tools for conducting financial analysis and evaluating investment and financial decisions.

The activity ratio is a vital indicator reflecting the company’s ability to allocate resources efficiently to generate revenue. The activity ratio is considered the link between the institution’s assets, its operating activities, and profit generation.

In this article, we review the concept of activity ratios in financial analysis, their types, and explain their importance and how to calculate them through a practical example. We also discuss their use in financial analysis to improve performance and inform strategic decisions.

What are activity or efficiency ratios?

Activity ratios are financial measures used to evaluate the efficiency with which an institution’s management employs its balance-sheet assets and moves them, in their various forms, to generate revenue and cash. Therefore, activity ratios are usually referred to as efficiency ratios.

Activity ratios appear in several forms, such as converting certain assets, such as inventory, goods, and customer balances, into liquid cash to operate and finance operations and achieve sales. This is reflected in profits and revenues and helps maintain the company’s financial position and operations.

Activity ratios also help the accounting sector evaluate and measure how a company manages inventory, sales, production, and customers, which affects the financial analysis process.

What is the importance of activity ratios?

The main objectives of activity ratios are to evaluate the profitability of institutions and companies and to measure management efficiency in applying financing and investment policies and in employing resources in a balanced manner to achieve profits and desired objectives. The importance of activity ratios includes the following:
 

1- Performance comparison

Efficiency ratios are used to compare the performance of two companies in the same field or sector.
 

2- Guiding investors’ decisions

Activity ratios help both financial analysts and investors assess the performance of an institution’s business activities. Simplified financial information derived from activity ratios helps investors assess whether the company is operating efficiently, thereby supporting the value of their investments and enabling comparisons among available investment options.
 

3- Evaluating operational efficiency and financial performance

These ratios measure the institution’s ability and effectiveness in utilizing and managing its assets and resources to achieve profits, which is known as evaluating the institution’s operating performance. Activity ratios also support financial analysis by evaluating and tracking the company’s financial position and by monitoring and analyzing it over different periods.
 

4- Detecting and solving financial problems

They help detect all financial problems and weaknesses that the institution may face, determine the institution’s ability to face challenges through the application of sound financial management strategies, and assist officials in developing and implementing corrective rules and decisions.
 

5- Working capital management

Efficiency ratios provide a comprehensive and integrated picture of working capital, which includes current assets and current liabilities. Activity ratios can be used to evaluate the efficiency of working capital management and the institution’s ability to improve the cash and liquidity cycle to meet short-term obligations.
 

6- Financial planning and budget preparation

Activity ratio analyses help in making managerial decisions related to production planning, preparing the projected budget, and allocating financial and human resources more effectively.

What are the types of activity ratios, and how are they calculated?

The importance of financial ratios lies in the fact that they determine the future of a company’s operations and the possibility of its expansion or lack thereof, as they are an indicator for measuring the extent of a company’s efficiency in managing the various items of the balance sheet. They also evaluate the speed with which capital and assets are converted into cash or sold.

These ratios can be calculated monthly, quarterly, or at the end of each financial period, as needed. Accounting software can also automate these ratios and calculations; however, it remains important to understand these ratios in order to analyze and interpret their results. Below are the most prominent types of activity ratios:
 

1- Fixed asset turnover ratio

This type of activity ratio indicates the extent of efficiency and success of institutions and companies in exploiting and using fixed assets to generate sales and increase profits. The higher the fixed asset turnover ratio, the more it indicates the institution's efficiency and success in managing its assets to generate sales.

Conversely, a low fixed asset turnover ratio indicates a discrepancy between the level of the company’s fixed asset investment and its sales.

Note: Some financial statements present fixed assets at net value after deducting accumulated depreciation. If the fixed assets are old, accumulated depreciation will be high, and the net asset value will be low.

For this reason, some financial analysts calculate the fixed asset turnover ratio using the total cost of fixed assets rather than their net value. This type is calculated as follows:

Sales / Net fixed assets (or average fixed assets) = Fixed asset turnover ratio

Example: If the company’s sales during 2022 amount to $150,000, the balance of fixed assets at the end of 2021 is $160,000, and the balance of fixed assets at the end of 2022 is $140,000.

Then the average fixed assets = (160,000 + 140,000) / 2 =$150,000

Fixed asset turnover ratio = 150,000 / 150,000 = 1 time

The system calculates the fixed asset turnover ratio by retrieving the necessary data from sales and asset management software.
 

2- Inventory turnover ratio

This type of efficiency ratio measures the number of times inventory is sold during a given financial period. In other words, it shows the number of times the institution was able to utilize and sell inventory to generate profit.

A low inventory turnover ratio indicates a defect in marketing management or a problem resulting from low product demand, whereas higher sales and inventory turnover rates indicate better company performance.

This activity ratio can be calculated based on the inventory turnover rate using the following accounting formula:

Cost of sales / Average inventory = Inventory turnover ratio

Average inventory = (Inventory balance of the previous year + Inventory balance of the current year) / 2

Example: If the company’s cost of sales is $120,000 for the year 2022, and the inventory balance in 2021 is $46,000 and in 2022 is $50,000.

Average inventory = (46,000 + 50,000) / 2 = $48,000 

Inventory turnover ratio = Cost of sales / Average inventory = 120,000 / 48,000 = 2.5 times

The inventory turnover ratio is calculated in the Daftra system by identifying the required data from the income statement and the accounting program to determine the cost of goods sold and the average inventory value. Instead of calculating the ratio in multiple steps, perform the calculation within the system to ensure more accurate results.

Read in detail about the inventory turnover ratio and how to calculate it
 

3- Accounts receivable turnover ratio

This type of activity ratio is concerned with measuring management efficiency in collecting its debts through credit sales. That is, it measures the number of times the company converted accounts receivable into cash during the accounting period. Activity ratios of this type depend on credit sales rather than cash sales.

It also evaluates the company’s ability to collect its receivables from others. Therefore, a higher accounts receivable turnover indicates a stronger cash position, as timely debt collection helps maintain cash flow and the company’s financial position. This ratio can be calculated as follows:

Accounts receivable turnover ratio = Net credit sales ÷ Average accounts receivable

Example: If the company’s net sales are $150,000 for the year 2022,
The balance of receivables in 2021 was $45,000, and in 2023 it was $55,000.

Average receivables = (45,000 + 55,000) / 2 = $50,000

Accounts receivable turnover ratio = 150,000 / 50,000 = 3 times

Instead of calculating the accounts receivable turnover ratio and then computing the average receivables, the Daftra system automatically computes these metrics by identifying the required data from the sales module, the income statement, and the customer accounts program.

You can download the accounts receivable template from here
 

4- Average collection period

Through activity ratios based on the average collection period, it is possible to measure the number of days the company held its inventory of goods before the sale process. A longer average selling period indicates inventory stagnation and weak marketing policies within the institution, which also affect working capital and liquidity.

The shorter the average selling period, or the period required to sell inventory, the more this indicates the efficiency of sales and warehouse management, which contributes to settling the company’s obligations and providing liquidity, as this ratio expresses the speed of collecting accounts receivable.

This activity ratio can be calculated according to the average collection period as follows:

Average collection period = (Accounts receivable) / (Daily credit sales)

Or
Average collection period = 360 / Accounts receivable turnover rate

Using the same example mentioned earlier:

Average collection period = 365 / 3 turnovers = 121 days

This means that the period required to collect trade receivables = 121 days

Daftra calculates the average collection period by extracting the required data from receivable accounts or the customer management program and then presenting it in an analytical report, table, or chart.
 

5- Current assets turnover ratio

This type of activity ratio indicates the ability and efficiency of an institution’s management in using and exploiting its current assets to generate sales and achieve profits. This ratio is measured at the end of the financial year, and the activity ratio depends on the nature of the field or sector and the factors affecting it.

It is worth noting that the higher the asset turnover ratio, the better it indicates the company’s performance. Efficiency ratios based on the current assets turnover rate are calculated as follows:

Current assets turnover ratio = Net sales / Current assets
 

6- Accounts payable turnover ratio

The activity ratio, according to the accounts payable turnover rate, indicates how quickly the institution settles its obligations. A higher rate indicates greater financial liquidity for the institution, or that it has obtained facilities and a longer payment period; conversely, a lower rate indicates less financial liquidity or a shorter payment period.

The activity ratio based on the accounts payable turnover rate is calculated as follows:

Accounts payable turnover ratio = Credit purchases / Accounts payable
 

7- Working capital turnover ratio

This ratio indicates the effectiveness of the institution in utilizing its capital to generate sales and profits. The higher the working capital turnover ratio, the more effectively the company uses its capital; the opposite indicates the presence of debt and inventory stagnation.

This ratio can be used to compare the institution’s activities with those of competing institutions in the same field.

The method of calculating this ratio is as follows:

Working capital turnover ratio = Sales or cost of goods sold / Working capital
 

8/ Total Asset Turnover Ratio

It refers to the total balance sheet, i.e., the number of times the institution successfully utilized all types of its assets to generate profit. A high ratio indicates the enterprise’s effective utilization of its assets; conversely, a low ratio indicates inefficient utilization.

Below is the method for calculating this ratio:

Total Asset Turnover Ratio = (Total Assets at the Beginning of the Period + Total Assets at the End of the Period) / 2

Example: If the company’s sales during the year 2022 amount to $150,000, the asset balance at the end of 2021 is $270,000, and the asset balance at the end of 2022 is $330,000.

= Average Assets

(270,000 + 330,000) / 2 = 300,000

Asset Turnover Ratio = 150,000 / 300,000 = 0.5 times
 

9/ Average Credit Period

It is the time period required for the credit period. The credit period is the period during which the company grants the customer to pay for the purchased product or service. The activity ratio according to the credit period can be calculated as follows:

365 / Average Credit Period = Working Capital Turnover Ratio

To calculate the average credit period in the Daftra accounting system, the system accesses financial reports and automatically computes the average using data from the purchases module and the beginning and end balances of accounts payable.
 

10/ Cash Cycle

This ratio measures the number of days required for the company to complete its net cash cycle, that is, the period between cash inflow and cash outflow.

Below is the method for calculating efficiency ratios based on the cash cycle:

Cash Cycle = Operating Cycle – Average Credit Period
 

11/ Operating Cycle

It is an activity ratio that measures the time period between the purchase of production and operating requirements, such as raw materials and others, and the collection of sales resulting from purchase operations. In brief, the activity ratio for the operating cycle is (the actual production period starting from the time of purchase until the collection of sales).

Below is how to calculate this ratio:

Operating Cycle = Average Collection Period + Average Holding Period

Calculating the operating cycle in the Daftra system requires accessing the inventory account, accounts receivable, and financial reports. The cycle is calculated automatically to derive the average storage period, collection period, and the complete operating cycle.

What do activity ratios measure?

Activity ratios are among the most important indicators of a company’s profitability, as profit results from several specific factors, such as the speed of asset turnover and working capital.

These ratios measure the efficiency with which the company operates fixed and current assets, including components of these assets, such as inventory and debtors, in generating profit from core operations. The way activity ratios are used can be clarified through the following aspects:
 

• Activity ratios in financial analysis measure the speed with which current assets are converted into inventory through increasing sales or into accounts receivable through the speed of collection. The greater the conversion speed, the greater the company’s ability to achieve profits more quickly.

Accordingly, through activity ratios, it is possible to identify problems related to slow inventory turnover and slow debt collection, and then make sound decisions.

• Activity ratios measure a company’s performance across different time periods and use the results of performance analysis to identify the reasons for decline and to take the necessary actions to drive progress and improvement.

How are activity ratios improved?

Improving activity ratios plays an important role in maintaining operational efficiency and enhancing asset utilization and inventory cycles. Below are the most prominent tips that help improve activity ratios and improve the management of the institution’s assets in a way that achieves profitability and operational efficiency at the same time:
 

• Improving inventory turnover and demand balance: using balanced demand strategies to reduce surplus and improve the inventory turnover rate to generate revenues and profits, reduce storage costs, and increase cash liquidity.
   
• Raising collection efficiency with an Arabic invoicing program: using an Arabic invoicing program for companies and stores to increase the efficiency of the cycle of collecting payments due from customers, track invoices, send payment reminder notifications to customers, and provide multiple payment options for customers that encourage them to accelerate payment.
   
• Delaying early payment to maintain cash flow: Avoiding early payment of invoices before their due date to maintain stable cash flow.
   
• Accurately estimating future cash flows: preparing accurate reports on estimates of future cash flows to avoid any potential shortage.
   
• Improving management: using Enterprise Resource Planning (ERP) systems to improve the management of data and operations related to assets, inventory, purchases, sales, and the operating cycle.
   
• Developing effective strategies: developing effective marketing strategies to increase sales and help retain existing customers, and attract new customers.

What are the steps for measuring activity ratios?

Measuring activity ratios helps evaluate and measure the efficiency and performance of the company in both inventory management and debt collection, which results in making informed decisions about improving the company’s financial performance. Activity ratios also help identify problems related to inventory or debts.

Accordingly, measuring activity ratios requires some steps to obtain accurate results for financial analysis. The most prominent steps for measuring activity ratios are:
 

• Collecting financial data: collecting financial data related to expenses and revenues in the income statement, as well as assets, liabilities, and equity in the balance sheet, and ensuring that the data is updated and accurate.
   
• Determining the type of activity to be analyzed: determining the type of activity ratios to be measured, such as the asset turnover ratio in general, the inventory turnover ratio, accounts receivable turnover ratio, the accounts payable turnover ratio, and other types and rates of activity ratios.
   
• Calculating the activity ratio: The activity ratio is analyzed using the rates previously explained.
   
• Comparing results: comparing the results of calculating efficiency ratios with industry standards, the company’s performance in previous periods, as well as comparing performance with competing companies to identify any shortcomings and develop specific plans to address them.
   
• Preparing an analytical report: preparing a report of activity ratio results with an explanation of the analysis related to each ratio or rate of activity ratios, and clarifying improvement recommendations and any other important conclusions.

Using an integrated, interconnected accounting system enables the automatic calculation of activity ratios in financial analysis. Therefore, I recommend that you evaluate the Daftra accounting system and customize it to suit your business activities.

What is the difference between liquidity ratios and activity ratios?

The difference between liquidity ratios and activity ratios is that liquidity ratios measure and evaluate an institution's or company's liquidity, specifically its ability to meet short-term obligations and debts by converting assets into cash. That is, they depend on liquidity and financial adequacy. They include several ratios, such as current, quick, and working capital ratios.

Activity ratios focus on the operational efficiency of institutional management in using the company’s available resources and converting them into profit.

What is the difference between profitability ratios and activity ratios?

In short, the difference between profitability ratios and activity ratios lies in the focus and purpose of each type of financial ratio. Profitability ratios focus on achieving an investment return, whereas activity ratios focus on improving the efficiency of the company’s operational processes and sales.

The difference is that profitability ratios focus on how to achieve a return on shareholders’ investments, such as the net profit margin and the return on assets. They are measured as percentages, and their primary objective is to increase profits, enhance shareholder value, and attract additional investment. Profitability ratios also focus on final results to evaluate the company’s success.

While activity ratios in financial analysis are measured in rates to reflect the institution’s efficiency in using assets to generate sales and profits, the main objective of efficiency ratios is to improve operational efficiency, increase productivity, and reduce costs.

Use the profit ratio calculator from Daftra to determine profit ratios across all your operations, free of charge.

What are the factors affecting the measurement of activity ratios?

Activity ratios are among the basic pillars for improving a company’s operational processes and evaluating its position and financial performance.

The measurement of activity ratios and asset utilization efficiency is influenced by several factors that must be considered. Below are some of the factors affecting the measurement of activity ratios:
 

1- Type of industry

Activity ratio measurement rates differ according to the nature of the industry itself. For example, the inventory turnover rate in the retail sector differs from that in the manufacturing sector.
 

2- Business strategies

Activity ratios are affected by the company’s policies for managing inventory turnover, sales strategies, methods, and means of collecting payments, and managing operational processes, including production and distribution.
 

3- Economic conditions

Economic recession or growth certainly has direct effects on demand and sales, which is reflected in activity ratios.
 

4- Attracting sources of financing

The company’s ability to obtain sources of financing or favorable credit terms can also affect investment in assets and increased activity.

By using the accounting software in the Daftra system, you can calculate activity ratios automatically, as efficiency ratios overlap with sales management programs, customer management, warehouses, and inventory management, and asset management, all of which are available and interconnected in the Daftra system.
 

Conclusion

In conclusion, understanding activity ratios in financial analysis is not merely about numbers that appear in financial reports, nor are they indicators limited only to financial analysis specialists.

Rather, their understanding extends to managers, investors, and even the public, thereby forming a forward-looking picture of the performance of competing institutions across industries. Therefore, care must be taken to apply efficiency ratios effectively to improve financial performance and ensure sustainable growth and expansion.

Frequently Asked Questions

What is the fixed asset efficiency ratio?

The fixed asset efficiency ratio is known as the fixed asset turnover ratio. It is one of the financial measures used to evaluate the performance of operational management in inventory cycles, debt, assets, and other areas.
 

What is financial activity?

Financial activity is a set of activities related to managing the company’s funds, whether they are transactional, investment, or financing activities.
 

How is efficiency measured?

Efficiency is measured by collecting data on all inputs, such as money, resources, and raw materials, and on outputs, such as the number of products or services. Use the following equation to calculate the activity ratio in financial analysis or the efficiency ratio:

Efficiency Ratio = Outputs ÷ Inputs
 

What is another name for the activity ratio?

The activity ratio in financial analysis is also called the efficiency ratio or working capital turnover. The objective of calculating the ratio is to evaluate the company’s performance in managing inventory, assets, and debts.
 

What does efficiency mean in ratios?

Efficiency in ratios in financial analysis means the measures used to evaluate the effectiveness of the company’s management in its various departments to ensure achieving profits and converting sales into positive returns.
 

What is the efficiency ratio indicator?

The efficiency ratio indicator is a percentage used in banks to calculate revenues and expenses to verify that the company is achieving profits. There are two indicators to determine the efficiency ratio:

• Low ratio: A low efficiency ratio indicates that expenses are low and profits are high.
• High ratio: A high efficiency ratio indicates that expenses are high and profits are low.
   

How are activity ratios calculated?

Calculating activity ratios in financial analysis is done by using a set of financial ratios that measure the performance and effectiveness of company management, represented in the following:

• Calculating the inventory turnover rate.
• Calculating the asset turnover rate.
• Calculating the accounts receivable turnover rate.
• Calculating the working capital turnover rate.

Finally, results for each turnover rate are compared with previous time periods, and sales trends, inventory management, and debt rates are examined.
 

What is the tax efficiency ratio?

The tax efficiency ratio is the percentage that indicates the amount of income during a specific period of time. A high tax efficiency ratio indicates a higher tax burden on the company. The tax efficiency ratio is calculated using the following equation:

Tax Efficiency Ratio = Net Return ÷ Gross Return × 100
 

What is the asset management and activity ratio?

The asset management and activity ratio is the asset turnover rate, which reflects the efficiency with which the company uses its assets to generate sales.