Activity Ratios

Activity ratios measure how efficiently a business is actually using its assets — how fast inventory turns over into sales, and how fast credit customers pay what they owe.

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Key things to remember

1Merchandise Turnover = Cost of Goods Sold ÷ Average Merchandise Inventory.
2Average Merchandise Inventory = (Opening Inventory + Closing Inventory) ÷ 2.
3Accounts Receivable Collection Period = (Average Accounts Receivable ÷ Net Credit Sales) × 365.
4Higher turnover and a shorter collection period generally both signal a faster, more efficient operating cycle.
5Both ratios measure SPEED/efficiency, unlike the balance-based liquidity and solvency ratios.

Liquidity and solvency ratios both look at balances — a snapshot at one moment. Activity ratios instead measure the SPEED of the business: how quickly is inventory turning into sales, and how quickly are customers turning their receivables into cash?

Merchandise Turnover

Merchandise Turnover is the number of times a company's average inventory is sold during an accounting period. A higher turnover generally means inventory isn't sitting around gathering dust — cash is being converted into sales and back into cash again, quickly. A turnover that is falling year over year can be an early warning sign of slow-moving or obsolete stock.

Merchandise Turnover = \frac{Cost of Goods Sold}{Average Merchandise Inventory}

Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2

The Accounts Receivable Collection Period

The Accounts Receivable Collection Period is the time it takes to collect accounts receivable — essentially, on average, how many days a customer takes to pay. A shorter collection period means cash comes back into the business faster, which is exactly the kind of information that feeds straight into the liquidity ratios from two topics ago.

Collection Period = \frac{Average Accounts Receivable}{Net Credit Sales} \times 365

Fig 1Turnover and collection period measure the speed of the operating cycle

These two ratios tell a connected story: fast merchandise turnover plus a short collection period means a business is racing through its full operating cycle (buy → sell → collect) quickly, which usually means it needs less cash tied up at any given moment to run the same volume of business.

Worked examples

Reveal one step at a time and try to beat it to the next line.

Example 1

A company has Opening Merchandise Inventory of $42,000, Closing Merchandise Inventory of $38,000, and Cost of Goods Sold of $184,000 for the year. Find Merchandise Turnover.

Example 2

A company has Average Accounts Receivable of $35,000 and Net Credit Sales for the year of $420,000. Find the Accounts Receivable Collection Period.

Where marks get lost

Using ending inventory alone instead of AVERAGE inventory in the merchandise turnover formula.
Using total Net Sales instead of Net CREDIT Sales in the collection period formula — cash sales were never on account, so they never had a collection period.
Assuming a higher turnover is always better with no limit — turnover that is too high can mean a business keeps running out of stock and losing sales.
Forgetting to multiply by 365 when converting the collection period ratio into a number of days.

Flashcards 5

Merchandise Turnover

The Accounts Receivable Collection Period

Merchandise Turnover formula

Collection Period formula

+ 1 more

Practice

Cost of Goods Sold $210,000; Opening Inventory $30,000; Closing Inventory $40,000. Find Merchandise Turnover.

Average Accounts Receivable $25,000; Net Credit Sales $365,000. Find the Collection Period in days.

days

A rising merchandise turnover ratio year over year generally suggests:

What should be used in the denominator of merchandise turnover — ending inventory or average inventory?

A shorter Accounts Receivable Collection Period means:

Cost of Goods Sold $312,000; Average Merchandise Inventory $52,000. Find Merchandise Turnover.

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