Subject: Principles of Accounting
Activity ratios measure a firm's ability to convert different accounts like assets, capital and liabilities within its balance sheets into cashor sales. So, activity ratios are the financial tools that are used to measure the ability of a company or firm to convert assets, liabilities and capital accounts to cash or sales. The faster a business is able to convert its assets into cash or sales, the more efficient it runs.
It is the relationship between the cost of goods sold during the year and the average inventory. It can be calculated as:
Inventory turnover ratio = \(\frac {Cost of goods sold}{Average inventory}\) = … times
When cost of goods sold & average inventory is unavailable,
Inventory turnover ratio = \(\frac {Sales}{Closing inventory}\) = … times
where,
Further, Inventory turnover ratio can be calculated in other ways too. Such as:
Illustration:
The followings are the information of ‘Vapp Co’:
Opening stock Rs. 30,000 | Closing stock Rs. 45,000 |
Purchase Rs. 55,000 | Carriage inward Rs. 7,000 |
Sales Rs. 1,80,000 | Carriage outward Rs. 5,000 |
Sales return Rs. 25,000 | Number of days in a year 365 days |
Required:
(a) Inventory turnover ratio
(b) Length of inventory cycle
Solution:
Here,
Cost of goods sold
= Opening stock + Purchase + Carriage inward – Closing stock
= 30,000 + 55,000 + 7,000 – 45,000
= Rs. 47,000
Average inventory
= \(\frac {Opening inventory+Closing inventory}{2}\)
= \(\frac {30,000+45,000}{2}\)
= Rs. 37,500
Then,
Inventory turnover ratio
= \(\frac {Cost of goods sold}{Average inventory}\)
=\(\frac {47,000}{37,500}\)
= 1.25 times
Also,
Length of inventory cycle
= \(\frac {Number of days in a year}{Inventory turnover ratio}\)
= \(\frac {365}{Current 1.25}\)
= 292 days
Debtors turnover ratio compares the sales of the uncollected amount from customers with whom goods were sold. This is to ascertain the efficiencyfor debt collection. Also known as receivable turnover ratio, it can be calculated as:
Debtors turnover ratio = \(\frac {Net credit sales}{Average debtors}\) = … times
When average debtors & credit sales are not available,
Debtors turnover ratio = \(\frac {Total sales}{Closing debtors}\) = … times
where,
Note: Total sales is taken as credit sales if there is no credit sales.
Illustration:
The following figures are given:
Particulars | Opening balance | Closing balance |
Debtors ……………………………. | Rs. 80,000 | Rs. 1,10,000 |
Account receivable………….. | Rs. 40,000 | - |
Total sales for the year………………………. Rs. 5,20,000
Sales return……………………………………….. Rs. 20,000
Required: Debtors turnover ratio
Solution:
Here,
Net credit sales:
= Total sales – sales return
= 5,20,000 – 20,000
= Rs. 5,00,000
Average debtors:
= \(\frac {Opening debtors + Closing debtors}{2}\)+ receivable
= \(\frac {80,000+1,10,000}{2}\)+ 40,000
= Rs. 1,35,000
Thus,
Debtors turnover ratio:
= \(\frac {Net credit sales}{Average debtors}\)
=\(\frac {5,00,000}{1,35,000}\)
= 3.7 times
Also known as Days sales outstanding or Receivable conversion period, it represents the average number of days for the collection of cash from debtors. It can be calculated as follows:
Average collection period = \(\frac {Days/ Week/ Month in a year}{debtors turnover ratio}\)
Average collection period = \(\frac {Debtors (12 months/ 52 weeks/ 365 days)}{credit sales}\)
Average collection period = \(\frac {debtors}{sales per day}\)
Illustration:
Total sales and sales return for the year are Rs. 5,00,000 and Rs. 1,50,000 respectively.
Account receivable:
1^{st} Baisakh…………… Rs. 90,000
31^{st} Chaitra…………… Rs. 50,000
Required:
(a) Debtors turnover ratio
(b) Average collection period
Solution:
Here,
Net credit sales
= Total sales – sales return
= 5,00,000 – 1,50,000
= Rs. 3,50,000
Average debtors
= \(\frac {Opening receivables+Closing receivables}{2}\)
= \(\frac {90,000+50,000}{2}\)
= Rs. 70,000
Then,
Debtors turnover ratio
= \(\frac {Net credit sales}{average debtors}\)
=\(\frac {3,50,000}{70,000}\)
= 5 times
Also,
Average collection period
= \(\frac {Days/ Week/ Month in a year}{debtors turnover ratio}\)
=\(\frac {365}{5}\)
= 73 days
This ratio is the inter relationship between net sales and fixed assets. This ratio determines the efficiency of the utilization of fixed assets. It is computed as:
Fixed assets turnover ratio = \(\frac {net sales}{net fixed assets}\) = … times
where,
Net sales = Total sales – sales return
Net fixed sales = Fixed assets – Accumulated depreciation
Note: Intangible assets such as patents, goodwill, trademark, etc. are included while calculating Net fixed assets whereas fictitious assets are excluded. However, if Net fixed assets is separately given in Balance Sheet, then the Intangible assets are too excluded.
Illustration:
The Balance Sheet of A.R.M.Y Co. is provided below:
Balance Sheet of A.R.M.Y Co.
As on 31^{st} December, 2015
Liabilities | Amount (Rs.) | Assets | Amount (Rs.) |
Share capital P&L a/c Debentures Creditors Accrued expenses | 5,00,000 40,000 80,000 25,000 15,000 | Goodwill Stock Land & building Preliminary expenses | 60,000 50,000 5,00,000 50,000 |
6,60,000 | 6,60,000 | ||
Cash sales during year……………………………. Rs. 7,00,000 Credit sales during year………………………….. Rs. 3,00,000 |
Required:
(a) Fixed assets turnover ratio
(b) Inventory turnover ratio
Solution:
Here,
Net sales
= Cash sales + Credit sales
= Rs. (7,00,000 + 3,00,000)
= Rs. 10,00,000
Net fixed assets
= Goodwill + Land & building
= Rs. (60,000 + 5,00,000)
= Rs. 5,60,000
Then,
Fixed assets turnover ratio:
=\(\frac {net sales}{net fixed assets}\)
=\(\frac {10,00,000}{5,60,000}\)
= 1.79 times
Also,
Inventory turnover ratio:
=\(\frac {Sales}{Closing inventory}\)
=\(\frac {10,00,000}{50,000}\)
= 20 times
Total assets turnover ratio is the ratio that expresses the relation between net sales and total assets, on a given date. This ratio is calculated as:
Total assets turnover ratio = \(\frac {net sales}{total assets}\)= … times
where,
Total assets = Current assets + Fixed assets – Depreciation + Investment + Intangible assets
Illustration:
Calculate Assets turnover ratio from followings:
Particulars | Amount (Rs.) |
Total sales ( credit sales included) Fixed assets Current assets Sales return | 5,00,000 2,00,000 60,000 1,10,000 |
Solution:
Net sales
= Sales – sales return
= Rs. (5,00,000 – 1,10,000)
= Rs. 3,90,000
Total assets
= Fixed assets + Current assets
= Rs. (2,00,000 + 60,000)
= Rs. 2,60,000
Hence,
Assets turnover ratio:
=\(\frac {net sales}{total assets}\)
=\(\frac {3,90,000}{2,60,000}\)
= 1.5 times
This ratio depicts the inter-relationship between the permanent capital (capital employed) and net sales. It can be computed as:
Capital employed turnover ratio =\(\frac {net sales}{capital employed}\)
Illustration:
Calculate Capital employed turnover ratio:
Liabilities | Amount (Rs.) | Assets | Amount (Rs.) |
Share capital Reserve & Surplus Debentures General reserve Current liabilities | 5,00,000 40,000 80,000 25,000 15,000 | Fixed assets Current assets Preliminary expenses Investment | 60,000 50,000 50,000 5,00,000 |
6,60,000 | 6,60,000 |
Sales…………………… Rs. 10,00,000
Sales return………... Rs. 70,000
Solution:
Here,
Net sales
= Sales – sales return
= Rs. (10,00,000 – 70,000)
= Rs. 9,30,000
Capital employed
= Share capital + Reserve & Surplus + General reserve – Preliminary expenses
= Rs. (5,00,000 + 40,000 + 25,000 – 50,000)
= Rs. 5,15,000
Therefore,
Capital employed turnover ratio:
=\(\frac {net sales}{capital employed}\)
=\(\frac {9,30,000}{5,15,000}\)
= 1.81 times
References:
Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu
Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu
Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu
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