Study Material & Notes for the Chapter 11
COMPANY - ACCOUNTING RATIOS
IV. ACTIVITY RATIOS
A. Meaning
- Activity ratios measure the efficiency or effectiveness with which a firm manages its resources.
- These ratios are also called turnover ratios because they indicate the speed at which assets are converted or turned over in Revenue from operations (sales).
- Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability
- These ratios are expressed as ‘times’ and should always be more than one. These ratios are also known as Turnover or Efficiency ratios.
B. Type
1. Inventory Turnover Ratio
2. Trade Receivables Turnover Ratio
3. Trade Payables Turnover Ratio
4. Working Capital Turnover Ratio
C. Inventory Turnover Ratio
a. Meaning
- It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration
- It expresses the relationship between the cost of revenue from operations and average inventory.
- It determines how many times inventory is purchased or replaced during a year.
b. Formula
- It is computed by dividing Cost of Revenue from Operations by Average Inventory
- Inventory Turnover Ratio = Cost of Revenue from Operation/Average Inventory
(i) Cost of Revenue From Operations = Net Sales +/– Gross Profit/Loss
(ii) Average Inventory = (Opening Inventory+Closing Inventory)/2
(iii) Cost of Revenue From Operations = Opening Inventory + Purchases (net) + Direct Expenses – Closing Inventory
c. Important Considerations
- The Inventory Turnover ratio is expressed in times
- This ratio measures how fast Inventory is moving and generating sales.
- The objective of calculating inventory turnover ratio is to ascertain whether investment in stock in trade is reasonable or not, ie, only the required amount is invested in stock-in-trade.
- It throws light on utilisation of inventory of goods. High turnover is good but it must be carefully interpreted as it may be due to buying in small lots or selling quickly at low margin to realise cash.
- Low turnover of inventory may be due to bad buying, obsolete inventory, etc., and is a danger signal.
- When figure of Cost of Revenue from Operations is not available, the Revenue from Operations may be put in place of Cost of Revenue from Operations. Similarly, if only closing inventory is given in the question, it may be treated as average inventory.
D. Trade Receivables Turnover Ratio
a. Meaning
- The liquidity position of the firm depends upon the speed with which trade receivables are realised.
- This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting period
- It expresses the relationship between credit revenue from operations and trade receivable.
b. Formula
- It is computed by dividing Credit Revenue from Operations by Average Trade Receivables
- Trade Receivables Turnover Ratio = Credit Revenue from Opertions/Average Trade Receivables
(i) Credit Revenue From Operations = Total Revenue From Operations – Cash Revenue from Operation
(ii) Average Trade Receivables = (Opening Trade Receivables+Closing Trade Receivables)/2
(iii) Trade Receivables = Debtors + Bills Receivables
Note: Provision for doubtful debts is not deducted
c. Important Considerations
- The Trade Receivables Turnover ratio is expressed in times
- This ratio shows efficiency in the collection of amount due from trade receivables.
- Higher the ratio, better it is since it indicates that debts are being collected more quickly.
- In general, a high ratio indicates the shorter collection period which implies prompt payment by debtor and a low ratio indicates a longer collection period which implies delayed payment for debtors.
- If Credit Sales is not specified, then total sales will be deemed as Credit Sales.
- If there is no mention of the opening trade receivables in the problem, then only closing trade receivables (debtors & bill receivables) we be considered as average trade receivables.
E. Average Collection Period
a. Meaning
- This ratio indicates in how many days receivables are getting collected by the Organization
- This is also known as Debt Collection Period or Credit period
b. Formula
- It is computed by dividing Number of days/weeks/months in a year by Trade Receivables Turnover ratio
c. Important Considerations
- The actual collection period can be compared with the stated terms of the organization
- If it is longer than stated credit terms, then this indicates inefficiency in the process of collecting debtors.
F. Trade Payables Turnover Ratio
a. Meaning
- Trade payables turnover ratio indicates the pattern of payment of trade payable.
- This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables.
- As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable.
b. Formula
- It is computed by dividing Net Credit Purchases by Average Trade Payables
- Trade Payables Turnover Ratio = Net Credit Purchases/Average Trade Payables
(i) Net Credit Purchases = Total Purchases – Purchase Returns – Cash Purchases
(ii) Average Trade Payables = Opening Trade Paybles+Closing Trade Paybles/2
(iii) Trade Payables = Creditors + Bills Payables
c. Important Considerations
- The Trade Payables Turnover ratio is expressed in times.
- This ratio shows the number of times the creditors are turned over in relation to purchases
- A high turnover ratio shows the availability of less credit or early payments, hence a low turnover ratio is beneficial for the organization.
- Trade Payables turnover ratio helps in judging the efficiency in getting the benefit of credit purchases offered by suppliers of goods. A high ratio indicates the shorter payment period and a low ratio indicates a longer payment period
- If Credit Purchases is not specified, then total purchases will be deemed as Credit Purchases.
- If there is no mention of the opening trade payables in the problem, then only closing trade payables (creditors & bill payables) we be considered as average trade payables.
G. Average Payment Period
a. Meaning
- This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables
b. Formula
- It is computed by dividing Number of days/weeks/months in a year by Trade Payables Turnover ratio
- Average Payment Period = Number of days or weeks or months in a year/Trade Payables Turnover Ratio
c. Important Considerations
- The average payment period can be compared with credit period offered by the suppliers.
- If it is longer than stated credit terms, then this indicates inefficiency in the process of settlement of creditors which may affect organization availability to get purchases on credit in future.
- A shorter payment period shows, organization is availing less credit period or making early payments.
H. Working Capital Turnover Ratio
a. Meaning
- Working capital turnover ratio measures the efficiency at which the working capital is utilised for business operations
- This ratio shows the relationship between working capital and revenue from operations.
- It shows the number of times the working capital has been rotated in generating sales in a year.
b. Formula
- It is computed by dividing Revenue From Operations by Working Capital
- Working Capital Turnover Ratio = Revenue from Operations/Working Capital
- Working Capital = Current Assets – Current Liabilities
c. Important Considerations
- The Working Capital Turnover ratio is expressed in times
- This ratio shows the number of times working capital has been employed in the process of carrying on business
- The objective of calculating Working Capital Turnover Ratio is to ascertain whether or not working capital has been utilized effectively in making revenue from operations
- A higher ratio indicates efficient utilisation of working capital in generating sales and a low ratio indicates the working capital is not properly utilised.