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.

Activity Ratios

• 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.
  receivables turnover = credit sales / average receivables
  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): number of days of receivables = average accounts receivable / (sales on credit/365)

• 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.
  inventory turnover = COGS / average inventory
  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.
  number of days of inventory = average inventory / (COGS/365)

• Payables 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
  payables turnover = purchases / average trade payables
  The following measures the number of days it takes for the company to pay its bills.
  number of days of payables = average accounts payable / (Purchases/365)

Cash Conversion Cycle

The cash conversion cycle is the time period that exists from when the company pays out money for the purchase of raw materials to when it gets the money back from the purchasers of the company's finished goods.

cash conversion cycle = days of inventory + days of receivables - days of payables

Example

Average accounts receivable: $25,400
Average inventory: $48,290
Average accounts payable: $37,510
Credit sales: $325,700
Cost of goods sold: $180,440.
Total purchases: $188,920

How many days are in the operating cycle? How many days are in the cash cycle?

1. The receivable turnover rate tells you the number of times during the year that money is loaned to customers. Credit sales / Average accounts receivable = 325,700 / 25,400 = 12.8228.

Receivables period = 365 days / 12.8228 = 28.46 days. This tells you that it takes customers an average of 28.46 days to pay for their purchases.

2. The inventory turnover rate indicates the number of times during the year that a firm replaces its inventory. COGS / Average inventory = 180,440 / 48,290 = 3.7366

Inventory period = 365 days / 3.7366 = 97.68 days. This means inventory sits on the shelf for 97.68 days before it is sold. That's ok for a furniture store but you should be highly alarmed if a fast food restaurant has a 98-day inventory period.

3. The accounts payable is matched with total purchases to compute the turnover rate because these accounts are valued based on the wholesale, or production, cost of each item.

Payables turnover = Total purchases / Average accounts payables = 188,920 / 37,510 = 5.0365
Payables period = 365 / 5.0365 = 72.47 days. On average, it takes 72.47 days to pay suppliers.

The operating cycle begins on the day inventory is purchased and ends when the money is collected from the sale of that inventory. This cycle consists of both the inventory period and the accounts receivable period. Operating cycle = 97.68 + 28.46 = 126.14 days

The cash cycle is equal to the operating cycle minus the payables period. It is the number of days for which the firm must finance its own inventory and receivables. During the cash cycle, the firm must have sufficient cash to carry its inventory and receivables.

Cash cycle = 126.14 - 72.47 = 53.67 days

In this example, the firm must pay for its inventory 53.67 days before it collects the payment from selling that inventory. Controlling the cash cycle is a high priority for financial managers.