Financial analysis indicators - activity
This series follows the series about Group of financial analysis indicators and describes in detail the indicators of activity.
Indicators of activity
Activity indicators evaluate the efficiency of the company in the use of its assets. They evaluate in particular how long the property holds its form, but it converts into sales or cash and turnover rate.
If the company holds:
- too much assets → inefficiency; in addition, the assets must be financed somehow, so the company pays "unnecessary" interest
- too little assets → the company may not be able to meet the customer´s demands within the agreed deadlines or respond to new market opportunities
→ the company should find a reasonable compromise
Disadvantages of activity ratios:
- valuation of assets and prices at which assets were acquired has a great influence (various purchase prices)
- it compares various assets from balance sheet, which is a fixed variable and the indicators of profit or loss (mostly sales), which is the sum of transactions over the entire period of time (usually a year). For this reason, balance sheet entries are often calculated as the arithmetic average of the beginning and end of the period and exclude the items that could not to have an impact on the income statement.
The indicators are divided into two mutually inverse groups:
- turnover period, i.e. how long the property holds its form, before it is converted into sales or cash. These indicators should be as low as possible.
→ calculation: selected asset or liability / revenue or costs * number of days in the year (360/365)
- turnover ratios, i.e. number of cycles during a period of time (usually 365 or 360 days). The higher are these indicators, the better.
→ calculation: sales and costs / selected asset or liability
→ calculation from turnover period indicators: 365 / given indicator of turnover period
Interpretation: important is trend.
Indicators of activity are:
- Asset turnover ratio (!)
- Fixed assets turnover ratio
- Inventory period / Days inventory outstanding (!)
- Receivables collection period / Average collection period (!)
- Days payable outstanding (DPO) (!)
- Cash conversion cycle
- Inventory turnover ratio
- Receivables turnover ratio
- Payables turnover ratio
Asset turnover ratio
Asset turnover ratio is one of the indicators of activity, which shows how efficiently the company manages its assets and expresses what revenues will be brought by unit of assets.
Unlike ROA, Asset turnover ratio uses revenues in the nominator, ROA has a profit there.
Calculation formula
Assets are often the average from the beginning and final balance.
Comparison
between companies in different industries does not make much sense because the indicator is usually higher in companies with low asset volume and high sales, and vice versa.
Fixed assets turnover ratio
Fixed assets turnover ratio is one of the indicators of activity which shows how efficiently the company manages its fixed assets and expresses what revenues are generated by unit of fixed assets.
Calculation formula
Non-current assets are often the average from the beginning and final balance.
Interpretation, comparison and recommended values
- generally, the higher the value, the better
- there is no general recommendation, how much indicator should come out
- important is the comparison over time
- appropriate is the comparison with companies in the same industry
- low values (observed mainly in the form of a decline in the time series) may indicate not sufficient utilization of production capacity or the fact that the company has too much fixed assets
Inventory period / Days inventory outstanding
Inventory period (Days inventory outstanding) is one of the indicators of activity, which indicates how many days is the inventory held in stock before it is sold.
If we divide number of days in the year (365) by the indicator of Inventory period, we get the indicator of Inventory turnover ratio.
If we sum up the Inventory and Receivables period days, we get the time during which is the inventory converted into revenue (potentially cash).
Calculation formula
Inventory is often the average from the beginning and final balance.
It is possible to use revenues instead cost of goods sold (sales costs, however, are preferable since they do not include margin).
Comparison
- comparison of companies in different industries makes little sense; on the contrary, benchmark with competition is useful
- meaningful is the comparison over time
Recommended values
- generally, the lower the inventory period, the better
- high values indicate either:
- slowdown in trading (although there are costs in the denominator, they are usually booked at the same time as revenues) – it is necessary to distinguish whether the slowdown in sales is merely relevant for the company only or whether it is the case for the entire industry or economy (recession)
- accumulation of inventories:
- general risks:
- inventory obsolescence and subsequent problems to sell it
- higher costs associated with holding stocks (e.g. costs of storage)
- inventory must be financed somehow, so the company pays "unnecessary" interest
- "justified" reasons:
- bargain purchases or discounts for buying in bulk
- seasonal fluctuations in demand
- expected price increases or shortages of certain stocks
- general risks:
- low values indicate either:
- the acceleration of sales
- low stock values:
- general risks:
- failure to fulfill customer orders
- inability of the company to respond to the challenges arising from the new business opportunities
- general risks:
Receivables collection period / Average collection period
Receivables collection period (Average collection period) is one of the indicators of activity, which indicates how many days it takes our customers to pay our receivables.
If we divide the number of days in the year (365) by the Receivables collection period indicator, we get Receivables turnover ratio.
Calculation formula
Receivables are often the average from the beginning and final balance.
Revenues can be adjusted for the sale in cash.
The obtained result may be distorted if
- receivables are not in the usual amount (e.g. are abnormally high)
- revenues do not include VAT, but claims do
Comparison
- indicator is most often compared with the usual delivery period
- comparison of companies in different industries makes little sense; on the contrary, comparison with competitive entities is very useful
- meaningful is the comparison over time
- advisable is the comparison with Days Payable Outstanding – DPO, which should exceed Receivables collection period
Recommended values
- desirable are low values, which may mean that the company:
- has a good working system of receivables collection
- has customers in good financial condition and/or with a good payment morale
- has a high proportion of sales in cash (however, unless sales in cash were deducted)
- conversed interpretations can be used for higher values; however, these can sometimes be justified by e.g. providing customers with longer maturities as a benefit during acquisition or retention process
Days payable outstanding
Days payable outstanding is one of the indicators of activity, which reflects how many days it takes us on average to settle our payables.
The indicator is well applicable during negotiating delivery terms with suppliers.
Calculation formula
Trade payables are often the average from the beginning and final balance.
It is possible to use revenues instead cost of purchases (costs, however, are preferable since they do not include margin). Costs of purchases are not usually shown separately in the accounting records and thus need to be ascertained.
Comparison most often with
- indicator is most often compared with the usual delivery period
- advisable is the comparison with Receivables collection period, which should be lower than Days Payable Outstanding
- meaningful is the comparison over time
Recommended values
- generally, high values are desirable, which may indicate that the company is able to negotiate advantageous delivery terms (de facto supplier credit)
- however, too high values may worsen the relationship with suppliers, or even indicate potential problems with deliveries
Cash conversion cycle
Cash conversion cycle is one of the indicators of activity and liquidity, which indicates the number of days beginning with the date of payment for purchased materials, labor and other costs up to collecting cash for the receivable.
Calculation formula
Inventory turnover period + Receivables turnover period – Days payable outstanding
Cash conversion cycle can thus be reduced by
- quicker collection of receivables
- shorter period of inventories held in stock
- prolonging the payments to suppliers
Inventory turnover ratio / Stock turnover ratio
Inventory turnover ratio (Stock turnover ratio) is one of the indicators of activity, which shows how many times during the period (year) is a unit of inventories converted into revenues (i.e. is sold).
Calculation formula
Inventories are often the average from the beginning and final balance.
Interpretation and appropriate comparatives
can be easily derived from the text presented within the indicator of Inventory period, because Inventory turnover can be calculated by dividing the number of days in the year (365) by the formula of Inventory period.
Receivables turnover ratio
Receivables turnover ratio is one of the indicators of activity, which shows how many times during the period (year) is a unit of receivable converted into sales.
Calculation formula
Trade receivables are often the average from the beginning and final balance.
Interpretation and appropriate comparatives
can be easily derived from the text presented within the indicator of Receivables collection period, because Receivables turnover ratio can be calculated by dividing the number of days in the year (365) by the formula of Receivables collection period.
Payables turnover ratio
Payables turnover ratio is one of the indicators of activity, which shows how many times during the period (year) is a unit of payables purchased.
Calculation formula
Trade payables are often the average from the beginning and final balance.
Interpretation and appropriate comparatives
can be easily derived from the text presented within the indicator of Days Payable Outstanding, because Payables turnover ratio can be calculated by dividing the number of days in the year (365) by the formula of Days Payable Outstanding.