The ratios presented in the textbook are neither exclusive nor uniquely "correct." The definition of many ratios is not standardized and may vary from analyst to analyst, textbook to textbook, and annual report to annual report. The analyst's primary focus should be the relationships indicated by the ratios, not the details of their calculations.

A company's operating activities require investments in both short-term (inventory and accounts receivable) and long-term (property, plant, and equipment) assets. Activity ratios describe the relationship between the company's level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

Receivables Turnover

Receivables turnover measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash.

This ratio provides a better level of detail than the current or quick ratio. A company could have a favorable current or quick ratio, but if the receivables turn over very slowly, these ratios would not be a good measure of liquidity. The same applies for the inventory turnover below.

This ratio also implies an average collection period (the number of days it takes for the company's customers to pay their bills):

Remember, as with all ratios, these ratios are industry specific. The nature of the industry dictates a higher or lower receivables or inventory turnover. For receivables turnover, analysts don't want to derive too much from the norm, since a low number indicates slow-paying customers that cause capital to be tied up in receivables and bad debt and a high number indicates overly stringent credit terms that hurt sales. If a company's credit policy is 30 days and the days of sales outstanding is 45 days, then the credit policy needs to be reviewed.

Inventory Turnover

Inventory turnover measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold.

An abnormally high inventory turnover and a short processing time could mean inadequate inventory, which could lead to outages, backorders, and slow delivery to customers, adversely affecting sales. An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory.

Payable Turnover

Payable turnover measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers.

The following measures the number of days it takes for the company to pay its bills.

Working Capital Turnover

Working capital turnover measures how efficiently a company generates revenue with its working capital. Working capital is defined as current assets minus current liabilities.

Total Asset Turnover

Total asset turnover is a measure of how many dollars of sales are generated by a dollar of assets. This number is smaller in capital-intensive industries since they have a higher investment in property, plants and equipment. It is also affected by the amount of leasing that is done by a company. Therefore, the ratio is very industry specific.

Accounting choices do affect ratios. Analysts must always be aware of accounting choices and how they affect the calculation of ratios. If a company leases most of its assets and they are classified as operating leases, which means they are not recorded on the balance sheet, then the company will have fewer assets and therefore a higher turnover ratio.

If a company writes down assets due to impairment, in the years following the write-down, assets will be lower and the turnover ratio higher.

The range of the asset turnover values should be consistent with the industry.

• An exceedingly high ratio might imply too few assets for the potential business (sales) or the use of outdated, fully depreciated assets.
• A low ratio might imply capital tied up in an excess of assets relative to the needs of the company.

The utilization of specific assets (e.g., receivables, inventories) should be examined to identify the cause of the change in total asset turnover.

Fixed Asset Turnover

Fixed asset turnover is a measure of a company's utilization of fixed assets.

net assets = gross fixed assets - depreciation on fixed assets.

This ratio should be compared to the industry norm. The impact of leased assets should be considered, particularly for industries such as retail and airlines that lease most of their fixed assets.

An abnormally high turnover ratio indicates that a company does not have enough capacity to meet potential demand or that the company may have obsolete equipment. Therefore, age of assets also affects this ratio. A higher ratio, caused by old assets, might look positive on the surface, but it would also imply the need for capital expenditures in the near future. Analysts must consider other factors (like age of assets) when considering which company is in a better position for the future. Age of assets is viewed as a factor by analysts because older assets imply the need for future cash outflows to replace assets. The ratio might look better for a company with older assets but the company is actually in a less favorable position than a comparable company that has replaced its assets and is using more efficient assets.

An abnormally low turnover ratio indicates that too much capital is tied up in excess assets.