What it means
Two businesses with the same sales and margins can need very different amounts of capital. One holds a month of stock, collects from customers in 30 days and turns its equipment over fast; the other holds three months of stock, waits 75 days to be paid and runs half-empty factories.
The second needs far more money invested to produce the same profit, and its return on capital is correspondingly lower. Activity ratios measure exactly these differences.
The working capital ratios are the most actionable. Inventory turnover, cost of goods sold divided by average inventory, shows how many times stock is sold through in a year; dividing 365 by it gives days of inventory.
Receivables turnover, credit sales divided by average receivables, gives days sales outstanding when converted to days. Payables turnover gives days payable outstanding.
Combined as days of inventory plus days receivable minus days payable, they give the cash conversion cycle: the number of days the business must finance its operations between paying for inputs and collecting from customers. Shortening that cycle releases cash with no change in profit.
The asset turnover ratios, fixed and total, measure the productivity of the whole asset base. They vary enormously by industry, from below 0.5 for utilities and heavy manufacturers to above 3 for retailers and service businesses, so they are compared with peers and with the company's own trend rather than with a universal benchmark.
A falling asset turnover means the company is investing faster than it is growing sales, which may be deliberate expansion or may be capital being wasted. Activity ratios connect to profitability through the DuPont identity: return on assets equals profit margin multiplied by asset turnover.
A business can improve its return either by earning more on each sale or by generating more sales from each dollar of assets, and the activity ratios show which lever is available.
In practice
Real-world examples.
Example
A supermarket has inventory turnover of 15 (24 days of stock), collects sales in cash (days sales outstanding near zero) and pays suppliers in 45 days, giving a negative cash conversion cycle: suppliers fund its operations.
Example
An aircraft manufacturer has inventory turnover of 1.2 (300 days of stock) because building an aircraft takes most of a year, and relies on customer deposits to fund the work.
Example
A software company has total asset turnover of 0.8 despite holding no inventory, because its balance sheet carries large amounts of cash and acquired goodwill.
Think of it
“Activity ratios measure how hard your assets are working-how efficiently you're using them.
Formula
Calculation
Inventory Turnover = Cost of Goods Sold / Average Inventory; Days of Inventory = 365 / Inventory Turnover
Receivables Turnover = Credit Sales / Average Receivables; Days Sales Outstanding = 365 / Receivables Turnover
Payables Turnover = Purchases / Average Payables; Days Payable Outstanding = 365 / Payables Turnover
Cash Conversion Cycle = Days of Inventory + Days Sales Outstanding minus Days Payable Outstanding
Total Asset Turnover = Revenue / Average Total Assets
Worked example. A kitchen appliance distributor reports for the year:
- Revenue (all on credit): $18,250,000
- Cost of goods sold: $13,140,000
- Purchases: $13,500,000
- Average inventory: $2,700,000
- Average receivables: $2,500,000
- Average payables: $1,480,000
- Average total assets: $9,125,000
Inventory turnover = $13,140,000 / $2,700,000 = 4.87; days of inventory = 365 / 4.87 = 75 days
Receivables turnover = $18,250,000 / $2,500,000 = 7.3; days sales outstanding = 50 days
Payables turnover = $13,500,000 / $1,480,000 = 9.12; days payable outstanding = 40 days
Cash conversion cycle = 75 + 50 minus 40 = 85 days
Total asset turnover = $18,250,000 / $9,125,000 = 2.0
The distributor finances 85 days of operations from its own capital. If it reduced inventory to 60 days (turnover 6.1) and collected in 40 days, the cycle would fall to 60 days, releasing roughly $1,040,000 of cash: 15 days of inventory at $36,000 a day and 10 days of receivables at $50,000 a day.Case study
Seen in the real world.
A plumbing supplies chain with 30 branches had seen its return on capital fall from 16% to 9% over four years while margins held steady. The finance director traced the decline through the activity ratios. Inventory turnover had fallen from 5.5 to 3.4 as branches added lines and central buying bought in bulk for discounts; days of inventory had risen from 66 to 107.
Receivables days had crept from 38 to 52 as trade credit was extended to win contractor customers. The cash conversion cycle had lengthened from 60 to 120 days, and the extra working capital, about $6 million, had all been borrowed. The chain cut its range by 20%, moved slow lines to central stock only, introduced credit limits and a collections routine, and stopped buying bulk discounts that cost more in carrying cost than they saved.
Two years later inventory turnover was back to 5.0, receivables days to 42, the cycle to 78 days, and $4.5 million of debt had been repaid. Return on capital recovered to 14% with no change in sales or margins.
Watch out
Common mistakes.
- Comparing activity ratios across industries. A supermarket and a shipbuilder have very different natural turnover rates.
- Using year-end balances rather than averages, which distorts the ratio for seasonal or growing businesses.
- Chasing high turnover at any cost. Too little stock loses sales; too aggressive collections lose customers.
Questions
People also ask.
Which activity ratio matters most?
For most businesses the cash conversion cycle, because it combines the three working capital ratios into the number of days of operations that must be financed.
How do activity ratios relate to profitability?
Through the DuPont formula: return on assets equals margin times asset turnover. Better turnover raises return without needing higher margins.
Are higher activity ratios always better?
Generally, but not without limit. Very high inventory turnover may mean stockouts; very high receivables turnover may mean credit terms too tight to compete.
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