Activity ratios, also known as efficiency or turnover ratios, measure how effectively the firm is using its assets. We will see, some aspects of activity analysis are closely related to liquidity analysis. In this aricle, we will primarily focus our attention on how effectively the firm is managing two specific asset groupsâ€”receivables and inventoriesâ€”and total assets in general.
In computing activity ratios for a company called Aldine Company, we will use year-end asset levels from the balance sheet. However, an average of monthly, quarterly, or beginning and year-end asset levels is often employed with these income statement/balance sheet ratios. The use of an average balance sheet figure is an attempt to better match the income statement flow item with a balance sheet stock figure more representative of the entire period, not just year end.
The receivable turnover (RT) ratio provides insight into the quality of the firmâ€™s receivables and how successful the firm is in collections. This ratio is calculated by dividing receivables into annual net credit sales:
Annual net credit sales/Receivables = RT ratio
If we assume that all 20×2 sales for Aldine are credit sales, this ratio is
$3,992,000 / $678,000= 5.89
This ratio tells us the number of times accounts receivable have been turned over (turned into cash) during the year. The higher the turnover, the shorter is the time between the typical sale and cash collection. For Aldine, receivables turned over 5.89 times during 20×2.
When credit sales figures for a period are not available, we must resort to using total sales figures. When sales are seasonal or have grown considerably over the year, using the year-end receivable balance may not be appropriate. With seasonality, an average of the monthly closing balances may be the most appropriate to use. With growth, the receivable balance at the end of the year will be deceptively high in relation to sales. The result is that the receivable turnover calculated is a biased and low estimate of the number of times receivables turned over during the course of the year. In this case, an average of receivables at the beginning and end of the year might be appropriate if the growth in sales was steady throughout the year.
The median industry receivable turnover ratio is 8.1, which tells us that Aldineâ€™s receivables are considerably slower in turning over than is typical for the industry. This might be an indication of a lax collection policy and a number of past-due accounts still on the books. In addition, if receivables are far from being current, we may have to reassess the firmâ€™s liquidity. To regard all receivables as liquid, when in fact a sizable portion may be past due, overstates the liquidity of the firm being analyzed. Receivables are liquid only insofar as they can be collected in a reasonable amount of time. In an attempt to determine whether there is cause for concern, the analyst may reformulate the receivable turnover ratio to produce receivable turnover in days (RTD), or average collection period.
Receivable turnover in days (RTD), or average collection period, is calculated as
Days in the year/Receivable turnover = Receivables x Days in the year/Annual credit sales
For Aldine, whose receivable turnover we calculated to be 5.89, the average collection period is
This figure tells us the average number of days that receivables are outstanding before being collected. Since the median industry receivable turnover ratio is 8.1, the average collection period for the industry is 365/8.1=45days. This disparity between the industryâ€™s receivable collection performance and Aldineâ€™s is once again highlighted.
However, before concluding that a collection problem exists, we should check the credit terms offered by Aldine to its customers. If the average collection period is 62 days and the credit terms are â€œnet 30â€? a sizeable proportion of the receivables are past the final due date of 30 days. On the other hand, if the terms are â€œnet 60,â€? the typical receivable is being collected only two days after the final due date.
Although too high an average collection period is usually bad, a very low average collection period may not necessarily be good. A very low average collection period may be a symptom of a credit policy that is excessively restrictive. The few receivables on the books may be of prime quality, yet sales may be curtailed unduly and profits may be because of the restrictive issuance of credit to customers. In this situation, perhaps credit standards used to determine an acceptable credit account should be relaxed somewhat.