Activity ratios are often the most ignored of the business ratios. In reality, they are the most important. Why?
The majority of activity ratios measure the ability of the company to turn assets into earnings. All businesses utilize a simple principle, buy an asset at a low price and sell it at a higher price. Even service based operations do this. Labor is purchased for a certain value and then sold for a much higher price. Retail businesses purchase inventory and then turn around, mark it up and then sell it to make a profit. There isn’t any business out there that doesn’t exercise this basic business tenet.
Activity ratios measure this aspect of business. With activity ratios, the word ‘Turnover’ is the common binding word used. When you hear the word turnover, think of an activity ratio.
All, except one, of the activity ratios are tied to the respective asset groups. For clarification, let’s review the respective asset groups.
Current Assets – This group consists of cash, inventory, receivables and prepaid expenses. Within this group, only two of the assets are tied to the income statement, i.e. turning assets into revenue. Inventory and receivables have a direct relationship to sales.
Fixed Assets – These assets exist in every business. Some industries have a greater reliance on fixed assets as access to that asset is what is being sold. For example, think of a utility company. They are selling the use of their plant to turn into energy or transfer energy. Real estate operations effectively rent out fixed assets. Manufacturing use fixed assets to produce products and so on. For many companies, there is a relationship between fixed assets and sales.
Total Assets – All assets added together equals total assets. Many users of business ratios will shortcut the system and just utilize total assets as a relationship to sales to determine activity performance. There are many issues with this generic approach as many operations have dead or dormant assets, assets as offsets to liabilities and investments held for future use.
There is one activity ratio that does not measure the ability to turn assets into sales or cash. This one measures the ability of the company to pay its bills. It is the accounts payable turnover rate. It is argued by some scholars that it should be in the liquidity group of ratios because of its relationship to cash. However, the frequency of paying vendors is often a reflection of activity with sales. The respective article on this site covering the accounts payable turnover rate explains this well and ties it to activity ratios.
Altogether, there are six activity ratios:
- Inventory Turnover Rate
- Receivables Turnover Rate
- Working Capital Turnover
- Fixed Assets Turnover Rate
- Total Assets Turnover Rate
- Accounts Payable Turnover Rate
Again, note that activity ratios relate a balance sheet section, mostly assets, to sales.
Proper Application of Activity Ratios
Of the six activity ratios, four are production based and two are performance tools.
Production activity ratios are 1) Inventory Turnover Rate, 2) Working Capital Turnover, 3) Fixed Assets Turnover Rate and 4) Total Assets Turnover Rate.
The Accounts Receivable and Payable Turnover Rates are used to evaluate the quality of the customer base and the ability of operations to timely pay the bills.
The key to proper application of activity ratios is understanding what type of asset is most utilized by the respective company. Greater credence is given to the inventory turnover rate for retail based operations. Those entities involved in production of inventory, emphasis shifts towards fixed assets turnover rate. For those organizations where inventory and equipment combined are essential to success, the total assets turnover rate is given more weight. To illustrate, let’s look at some publicly traded companies and select the best activity ratio to apply.
Inventory Turnover Rate
Department stores, grocery chains, specialty stores (clothing, shoes, jewelry etc.), and hardware chains are perfect examples of emphasizing the inventory turnover rate to evaluate performance.
Let’s compare two publicly traded hardware chains. Let’s compare Lowe’s and Home Depot to see which one has the better inventory turnover rate.
The formula for the inventory turnover rate is:
Inventory Turnover Rate = Cost of Goods Sold During the Accounting Period
Average Value of the Inventory
Lowe’s results for 2018 and 2017 are:
$48.8 Billion = 3.87 (2018) $46.2 Billion = 4.05 (2017)
$12.6 Billion $11.4 Billion
Home Depot for 2018 and 2017 are:
$71.0 Billion = 5.11 (2018) $66.5 Billion = 5.23 (2017)
$13.9 Billion $12.7 Billion
Naturally, there are advantages Home Depot has over Lowe’s including more retail stores. But notice something important here, both businesses saw their respective inventory turnover rates decrease. Lowe’s decreased 4.5 percent, whereas Home Depot decreased 2.3%.
In general, Home Depot outperformed Lowes related to this activity ratio. Home Depot’s overall rate is superior and its year on year change was better too.
This business ratio, inventory turnover rate, is effective if applied correctly.
Working Capital Turnover Rate
Working capital refers to the excess amount of current assets over current liabilities. It is the amount of available capital to increase productivity. There are multiple nuances involved, the article, working capital turnover rate, in this section of the website goes into extreme detail with this particular ratio.
This particular ratio is well suited for all industries and it is in the best interest of the reader to fully understand this ratio to take advantage of the respective results.
Some industries have little to no inventory. They rely almost exclusively on their fixed assets to generate revenue.
Fixed Assets Turnover Rate
Fixed assets intensive industries are those that have huge up-front investments in real estate, structures, equipment and/or technology to generate revenues. Good examples include REIT’s, resorts, transportation, hospitality and entertainment industries. Pharmaceutical industries marginally fit into this category too. However, they do have a large investment into research and development that is often capitalized as an asset in ‘Other Assets’ once a patent is issued. But that’s a different subject for a different function. For now, exclude pharmaceutical from this section.
One thing I have learned is that invariably, the fixed assets turnover rate improves from year to year; at least it should. Why? Well, the key is the formula for this ratio. The denominator is the historical cost of the fixed assets. For those companies with large investments, especially early on in their lives, the dollar amount is weighted down due to inflation. Basically, the only way to have a truly accurate value is to use fair market values for the respective assets. This makes it complicated and convoluted to determine the true year on year fixed assets turnover rate. For comparative purposes, the user would have to apply a cost adjustment factor for all prior years which will change every year.
When using this formula, you should expect improvement from year to year. Some of that improvement is related to the effect of older assets at older dollar values. Therefore, keep this in your mind when evaluating the outcome.
A good example for this activity ratio is the comparison of two railroad companies. Note that they are in the transportation sector of the economy. Again, transportation industries are asset intensive businesses. Let’s look at the results for two large publicly traded railroad companies, Norfolk Southern and Union Pacific. Here are their results:
Revenues $11.5B = .264:1 $10.6B = .252:1
Fixed Assets $43.5B $42.2B
Revenues $21.4B = .294:1 $19.8B = .280:1
Fixed Assets $72.8B $70.8B
Union Pacific improved 5% from 2017 to 2018, whereas Norfolk Southern improved 4.76%. Based on this, the novice user of ratios would believe that Union Pacific did a better job at improving their ratio. The reality is starkly different. Notice the much greater fixed asset value for Union Pacific. A sophisticated business investor will understand that a good portion of this value relates to historical costs at older dollars. Thus, the user of this value should expect a significantly better gain in ratio than a mere 4.8% [.05/(.05 – .0476)] over Norfolk Southern.
These nuances are explained in the chapter for this respective ratio. The point is that this formula along with other formulas can be and are complex. A user must still use their experiences and knowledge of the business sector and the overall economy to evaluate the results. In effect, take the results in perspective and not as an absolute value.
One last thing, in 2016, Union Pacific’s fixed assets turnover ratio was .270:1. Therefore, 2017’s improvement was 3.7%. This means that Union Pacific did a much better job at improving this ratio from 2017 to 2018 than the prior year. Improvement is what a user of business ratios is really trying to ascertain. As stated multiply times throughout the articles for business ratios, look for improvement not an absolute value.
Total Assets Turnover Rate
Within the group of activity ratios, the total assets turnover rate is the broadest in scope. Similar to other activity ratios, it utilizes net sales as the numerator. However the denominator doesn’t focus in on a single balance sheet asset group like the working capital turnover or fixed assets turnover rates, it includes all assets. This means all other assets (non-current and intangible assets).
The total assets turnover rate is really an all-encompassing blanket activity ratio. The other activity ratios have parameters and are more beneficial especially to businesses that depend heavily on its sales from that particular asset group. As an example, retail relies more on inventory than fixed assets. Some companies rely distinctly on unique assets for their sales. Here are some examples:
* Entertainment is almost entirely operated sourced from their copyrights to movies, music, games etc. to earn their income.
* Pharmaceuticals depend on research and development of new drugs and approval from the Food and Drug Administration; in effect, federal permission to sell their products.
* Communications is centered on owning a part of the frequency spectrum sold by the government. This sole ownership of the airwaves frequency allows them to charge fees from advertisers.
* Professional sports purchase talent with contracts from ball players. These potential stars generate ticket sales and marketing rights allowing the franchise to recoup their costs. These types of businesses rely essentially on intangible assets to generate revenue.
Receivables Turnover Rate
This particular activity ratio has two purposes. Its overall purpose is to evaluate the collection frequency of the receivables. The average person would tend to think that it helps to determine liquidity, the ability to liquidate the receivables for cash flow purposes. This is generally its purpose. But it really tells another story. It helps the user to understand the quality of customers for the company. Good customers pay timely; its that simple. Marginal customers take longer to pay their bills and this is a bad sign for business operations.
As the ratio decreases (customers take longer to pay) it points to the following potential problems:
- Increases in bad debt
- Gross profit margin decreases (the company is selling to more price conscious customers)
- Potential insolvency
This particular ratio is an indicator of success. The key is to maintain consistency from one period to the next. This tells the reader that management is keeping tabs on its customers and that cash receipts will continue in a normal pattern into the future assuming sales continue in a similar pattern.
Accounts Payable Turnover Rate
The receivables turnover rate is an asset side of the balance sheet activity ratio. Actually, five of the six activity ratios are asset driven. The accounts payable turnover rate is the only activity ratio that is liability driven. It measures the frequency of paying the corporate bills in a timely manner.
In general, as the frequency increases, it is a sign that cash is available to pay the bills. Cash is provided from three different sources. The first is of course the sale of stock. This occurs infrequently and is generally not one of the reasons accounts payable would be paid more frequently. The second source is borrowing money. For larger companies, the issuance of debt is generally used to purchase fixed assets or replace existing debt, not to pay bills.
The third source of cash is what most frequently affects the ability to pay bills. That is of course sales. If sales generate good margins, then in general the accounts payable turnover rate will increase over time. Profits put extra cash into the bank account allowing management to pay the bills faster ultimately reaching a pinnacle rate that will be consistent from one period to the next. Now any excess cash is used to pay down debt and reward the shareholders.
Summary – Activity Ratios
Keep in mind, activity ratios are the heart (lifeblood) of the ability of the company to be successful. They truly measure the ability to perform. Remember what business is all about, buy low, sell high. The four production based activity ratios of inventory, working capital, fixed and total assets turnover measure this ability to produce. Of course, all four are not applicable to every business. Each industry is different and so the sophisticated user of ratios applies the best one of these four or a weighted approach to the respective industry when evaluating performance.
The other two activity ratios are utilized to measure the quality of overall operations. Better customers, better margins provide better receivables and payables turnover rates. ACT ON KNOWLEDGE.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.