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Meaning of Activity Ratio

Activity ratios indicates the efficiency with which a business uses its assets, such as inventories, accounts receivable, and fixed assets. Activity ratios measures how effectively a company is able to generate revenue in the form of cash and sales by using its asset, liability and capital.

Importance of Activity Ratio

As said above Activity ratios play an active role in evaluating a company’s operating efficiency because, in addition to expressing how well a company generates revenue, activity ratios also indicate how well the company is being managed with the best utilization of all of its balance sheet components.

Some examples of Activity Ratio

The most commonly used operating ratios are the average (debtors) collection period, the inventory turnover, the fixed assets turnover, and the total assets turnover ratios. So let’s have a brief discussion on these items.

1. Inventory turnover ratio :

This ratio indicates the number of times a company’s investment in inventory is turned over into revenue during a given year. The higher the turnover ratio, the better the company’s performance is since a company with a high turnover requires a smaller investment in inventory than one producing the same level of sales with a low turnover rate.

2. Average collection period :

Average Collection Period. This ratio measures how long an entity’s average sales remains in the hands of its customers. A longer collection period automatically creates a larger investment in assets.

3. Fixed assets turnover :

Fixed Assets Turnover is an indication of the productivity of the entity. The fixed assets turnover ratio measures how intensively a firm’s fixed assets such as land, buildings, and equipment are used to generate revenue. A low fixed assets turnover implies that a firm has too much investment in fixed assets relative to sales.

4. Assets turnover ratio :

This ratio considers both the net fixed assets and current assets. It also gives an indication of the efficiency with which total assets of the company are used where fixed assets turnover measures only the effective use of fixed assets .a low ratio means that excessive assets are employed to generate sales and some assets should be liquidated in order to avoid the excessive costs associated with fixed assets. Recommended

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