CHAPTER - 4

ACTIVITY/TURNOVER RATIO
4.1. INTRODUCTION:
Firm invests funds of outsiders (lenders and creditors) and shareholders in
various assets in business to make sales and profits. The better the management of
assets, more would be sales and higher would be the profit.
Activity ratio reflect the management of assets and their effective utilization. If
assets are converted into sales, with speed, profits would be more. Activity ratios
bring out the relationship between the assets and sales. It is also called as Asset
Efficiency or Operating Efficiency or Activity/Turnover Ratio. For example, funds
invested in inventories are converted or turned over into sales. Activity ratios are
employed to evaluate the efficiency with which the firm manages and utilizes the
assets, in particular, debtors and stock. Turnover ratios are also known as activity
ratios or efficiency ratios with which a firm manages its current assets.
Note: Both current ratio and acid test ratio may give misleading results. If
current assets include high volume of debtors, due to slow credit collections, current
assets would be high, resulting in a high current and acid test ratio. These ratios fail
to show the movement of debtors, as they do not exhibit the quality of debtors.
Similarly, if inventories were non-moving or obsolete and not written off, current ratio
would be high. It is important to calculate the turnover of these assets to ascertain
their quality and how efficiently these assets are used in the business.
4.2. TYPES OF TURNOVER RATIO:
The following turnover ratios can be calculated to judge the effectiveness of asset
use.
1.
2.
3.
4.

Inventory/Stock Turnover Ratio

Debtor/Receivable Turnover Ratio
Assets Turnover Ratio
Creditor/Payable Turnover Ratio

4.2.1 Inventory/Stock Turnover Ratio

Inventory turnover ratio is also known as stock turnover ratio. It indicates the
number of times the inventory has been converted into sales during the period. Thus
it evaluates the efficiency of the firm in managing its inventory. This is generally
calculated by dividing sales by calculated by inventory. However, it may also be
calculated as dividing cost of goods sold by average inventory.

Cost of Goods Sold = Opening Stock + Purchases Closing Stock

= Net Sales Gross Profit
Importance:
Inventory turnover ratio shows the velocity of stocks. A higher ratio is an
indication that the firm is moving the stocks better so profitability, in such a
situation, would be more. However, a very high ratio may show that the firm has
been maintaining only fast moving stocks. The firm may not be maintaining the total
range of inventory and so may be missing business opportunities, which may
otherwise be available.

It is better to compare the turnover ratio, with the industry or its immediate
competitor.
Days of Inventory Holdings:
If we want to know the holding of inventory in the form of number of days, the
following formula helps us.

It is also called as the days' sales in inventory ratio.

Ideal Standard: There is no standard ratio. The ratio depends upon the nature of
business. The ratio has to be compared with the ratio of the industry, other firms or
past ratio of the same firm.
Every firm has to maintain certain level of inventory, be it raw materials or
finished goods, to carry on the business, smoothly, without interruption of production
and loss of business opportunities. Inventory Turnover Ratio is a test of inventory
management.
This level of inventory should be neither too high nor too low. If the ratio
is too high, it is an indication of the following:

(i) Blocking unnecessary funds that can be utilized somewhere else, more profitably.
(ii) Unnecessary payment for extra go down space for piled stocks.
(iii) Chances of obsolescence and pilferage are more.
(iv) Likely deterioration in quality and
(v) Above all, slow movement of stocks means slow recovery of cash, tied in stocks.
On the other hand, if the ratio is too low:
(i) Stoppage of production, in the absence of continuous availability of raw materials
and
(ii) Loss of business opportunities as range of finished goods is not available, at all
times.
To avoid the situation, the firm should know the position, periodically, whether
it is carrying excessive or inadequate stocks for necessary corrective action, in time.

4.2.2 DEBTORS (RECEIVABLES) TURNOVER RATIO

Firms sell goods on cash and credit. As and when goods are sold on credit,
debtors (receivables) appear in accounts. Debtors are expected to be converted into
cash, over a short period, and they are included in current assets. To judge the
quality or liquidity of debtors, financial analysts apply following ratios, which are:
(a) Debtors turnover ratio
(b) Collection period
(a) Debtors Turnover Ratio:
Debtors turnover is found out by dividing credit sales by average debtors.

Net credit sales consist of gross credit sales minus sales return. The trade
debtors for the purpose of this ratio include the amount of Trade/Sundry Debtors &
Bills Receivables. The average receivables are found by adding the opening
receivables and closing balance of receivables and dividing the total by two.
But when the information about opening and closing balances of trade debtors and
credit sales is not available, then the debtors turnover ratio can be calculated by
dividing the total sales by the balance of debtors (inclusive of bills receivables) given.
Debtor Turnover Ratio = Total Sales/Trade Debtors
Debtors turnover ratio indicates the number of times debtors are turned over,
each year. The higher the debtors turnover, more efficient is the management
of credit.
(b) Collection Period:
The collection period/ the days' sales in receivables ratio is calculated by

*360 days are taken in place of 365 for convenience in calculation only.
Signals of Collection Period
Debtors Turnover Ratio indicates the speed of their collection. The shorter the
period of collection, the better is the quality of debtors. A short collection period
indicates the efficiency of credit management. The average collection period should
be compared with the credit terms and policy of the firm to judge the quality of
collection efficiency.

4.2.3 ASSET TURNOVER RATIO :

The relationship between assets and sales is known as assets turnover ratio.
Several assets turnover ratios can be calculated depending upon the groups of
assets, which are related to sales.
a) Total asset turnover ratio
b) Net asset turnover ratio
c) Fixed asset turnover ratio
d) Current asset turnover ratio
e) Working capital turnover ratio
(a) Total Assets Turnover Ratio
Assets are used to generate sales. If the firm manages the assets more
efficiently, sales would be more and equally profits would be up. This ratio is
calculated by dividing sales by total assets.

Importance: A firms ability to make sales indicates its operating performance.

Caution: This ratio should be interpreted, carefully. Between two firms, a firm having
old assets, with lower depreciated book value of fixed assets, may generate more
sales compared with a firm, with new fixed assets purchased, recently. The firm, with
old assets, may generate a misleading impression of higher turnover, without any
actual improvement in sales.
(b) Net Asset Turnover Ratio:
This is calculated by dividing sales by net assets.
Net asset turnover ratio = Total Sales/ Net Assets
Net assets represent total assets minus current liabilities.

Intangible and

fictitious assets like goodwill, patents, accumulated losses, deferred expenditure may
be excluded for calculating the net asset turnover.

(c) Fixed Asset Turnover Ratio:

This ratio is calculated by dividing sales by net fixed assets.
Fixed asset turnover ratio = Total Sales/ Net Fixed Assets
Net fixed assets represent the cost of fixed assets minus depreciation.

(d) Current Asset Turnover Ratio:

It is divided by calculating sales by current assets
Current asset turnover ratio = Total Sales/ Current Assets
(e) Working Capital Turnover Ratio
The WCT Ratio indicates the velocity of utilization of working capital of the
firm, during the year. The working capital refers to net working capital, which is equal
to total current assets less current liabilities. The ratio is calculated as follows:

Working capital is represented by the difference between current assets and current
liabilities.
Importance:
This ratio measures the efficiency of working capital management. A higher
ratio indicates efficient utilization of working capital and a low ratio shows
otherwise. A high working capital ratio indicates a lower investment in working capital
has generated more volume of sales. Higher ratio improves the profitability of the
firm. But, a very high ratio is also not desirable for any firm. This may also imply
overtrading, as there may be inadequacy of working capital to support the increasing
volume of sales. This may be a risky proposition to the firm. The ratio is to be
compared with the trend of the other firms in the industry for different periods to
understand the right working capital ratio, without resulting overtrading.

4.2.4. CREDITORS / PAYABLE TURNOVER RATIO:

In the course business operations of the firm, a firm has to make credit
purchases and incur short-term liabilities. Before supply of goods, suppliers can
check up the ratio to understand the normal period of payment, firm has been
making, for the goods supplied. The ratio is calculated, similar to debtors turnover
ratio. In the place of debtors, creditors are to be substituted and credit purchases in
place of credit sales. It indicates the number of times sundry creditors have been
paid during a year. It is calculated to judge the requirements of cash for paying
sundry creditors. The ratio can be calculated

Net credit purchases consist of gross credit purchases minus purchase return.
When the information about credit purchases, opening and closing balances
of trade creditors is not available then the ratio is calculated by dividing total
purchases by the closing balance of trade creditors.
Creditor Turnover Ratio = Total purchases/ Total Trade Creditors
Similarly, to understand the number of days the creditors are outstanding,

Interpretation:
Payment Period Creditors Turnover Ratio indicates the number of days the
creditors are outstanding for payment. If the number of days is lower than the
assured period of payment, it indicates liquidity of the firm. This would be good news
to the suppliers as they can expect the payment, within the assured period.