What Are Activity Ratios?

As an individual investor, it’s important to do your own research about companies you invest in. The best way to do this is to analyze financial metrics and ratios to get a feel for a company’s overall financial health.

You can use financial ratios to compare companies in the same or similar industries. However, keep in mind that many ratios are interrelated and should be examined together rather than independently.

One specific group of metrics you’ll want to familiarize yourself with are activity ratios. We touch on what activity ratios are as well as how investors can use them to evaluate a company.

What Are Activity Ratios?

Activity ratios, also referred to as efficiency ratios, are a set of financial metrics that are used to measure how well a company utilizes its current assets to generate revenue over a specific time period. Efficiency ratios provide an idea of the overall operational performance of a firm. Investors often use activity ratios to compare two different companies in the same sector or industry.

Types of Activity Ratios

When it comes to understanding activity ratios, you need to know the various metrics used to measure a company’s ability to convert assets into revenue. The most common types of activity ratios include:

• Inventory turnover: measures the number of times inventory is sold and replaced in a certain time period
• Receivables turnover: measures the effectiveness of a firm’s credit policies and helps to indicate how quickly and efficiently a company collects on its outstanding bills.
• Payables turnover: measures how quickly a company pays off the money owed to suppliers
• Asset turnover: how efficiently a company uses its total assets to generate revenues

These turnover ratios help investors to evaluate a company’s ability to generate revenue from the assets on its balance sheet. Even though there are several different types of activity ratios, you will want to use these in conjunction with other key financial metrics to get the full picture.

Other Types of Activity Ratios

Depending on how the investor wants to compare companies in the same industry, they may use other types of activity ratios like:

• Total assets turnover ratio: company’s total sales divided by total assets; measures how efficiently a company uses its assets to tender a sale
• Average collection period: converts the receivables turnover ratio into a more intuitive number by showing the average number of days receivable are outstanding before they are collected

What Do Activity Ratios Measure?

Activity ratios measure the rate at which the company is turning over its assets or liabilities. In other words, activity ratios present investors with data that showcases how many times per year inventory is replenished or receivables are collected.

Additionally, activity ratios help potential investors and shareholders to evaluate a company’s operating efficiency by analyzing its assets, inventory and accounts receivable.

As we mentioned above, activity ratios are often used to compare two competing businesses in the same industry to determine how a particular company stacks up against others in the same sector. You can also use activity ratios to evaluate one company over time to determine if there are long-term changes in how well assets are being managed at the company. Companies that have good management and overall financial health show gradual improvement in their activity ratios.

Both activity ratios and profitability ratios are fundamental analytical tools that help investors to evaluate different facets of a company’s fiscal strength. Ratios that fall under the activity and profitability umbrella are often used in conjunction with one another to understand where a company has been and where it’s headed regarding its ability to generate sufficient revenue.

Where Can You Find Activity Ratios?

Now that you know how activity ratios are used, how do you find them? Since stocks listed on U.S. stock exchanges are public companies, their financial statements and business activities are available to shareholders.

You can easily find the components to calculate activity ratios on the income statement, which measures performance over a specified period, and the balance sheet, which presents data as of one point in time. To make the items comparable for use in activity ratios, an average figure is calculated for the balance sheet data using the beginning and ending reported numbers for either the quarter or the year, depending on the company’s accounting practices.

Using Activity Ratios to Invest

Good financial analysis starts with understanding how to use metrics such as activity ratios to your advantage. With activity ratios, investors gauge the future of a company and develop a feel for its attractiveness as measured by factors such as its performance and financial strength compared to its competitors in the same industry.

Knowing how to use activity ratios can give you an advantage in evaluating a company on how efficiently it is able to leverage its total assets to generate revenue over a period of time.

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Members can search any company on the AAII website to see specific stock metrics for different types of investing approaches, including ways to measure a company’s worth and viability with ratios.

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