Activity ratios: turnover, days and the cash conversion cycle

What do activity ratios measure?

How efficiently a company uses its working capital and its assets. Activity ratios (also called asset utilization or operating efficiency ratios) put an income statement flow on top and a balance sheet stock below.

Because the flow covers a whole period and the balance sheet is a snapshot, the balance is normally the average of the opening and closing figures. Working capital efficiency also feeds liquidity, which is why the cash conversion cycle appears again in the next lesson.

Activity ratiosefficiency: flow ÷ average balance

• Working capital Memorize
  • Inventory Memorize turnover on COGS, then DOH
  • Receivables Memorize turnover on revenue, then DSO
  • Payables Memorize turnover on purchases, then days
  • Working capital turnover Use it revenue ÷ working capital
• Long-term assets Use it
  • Fixed asset turnover revenue ÷ net fixed assets
  • Total asset turnover revenue ÷ total assets
• Cash conversion cycle Memorize DOH + DSO − days of payables

How do you calculate turnover and days?

Divide the flow by the average balance to get turnover, then divide 365 by turnover to get days.

Memorize

$$\text{Inventory turnover} = \frac{\text{COGS}}{\text{average inventory}}$$

$$\text{Receivables turnover} = \frac{\text{revenue}}{\text{average receivables}}$$

$$\text{Days} = \frac{365}{\text{turnover}}$$

The inventory turnover shows how many times stock is sold and replaced in a year, and days of inventory on hand (DOH) converts it to days of stock. Receivables turnover and days of sales outstanding (DSO) do the same for customer credit.

How is payables turnover different?

It uses purchases, not COGS, because payables arise when the company buys goods. Purchases are not on the income statement, so rebuild them from COGS and the change in inventory.

$$\text{Purchases} = \text{COGS} + \text{ending inventory} - \text{beginning inventory}$$

$$\text{Payables turnover} = \frac{\text{purchases}}{\text{average trade payables}}$$

Payables turnover converts into the number of days of payables by 365 ÷ turnover, the average time the company takes to pay suppliers.

Exam tip The curriculum’s table lists cost of sales as the numerator for payables turnover, and data providers often use it as an approximation. Use purchases whenever the question gives inventory balances or tells you purchases, and COGS when it gives nothing else.

What is the cash conversion cycle?

It is the time between paying for stock and collecting from customers, in days. A company that holds stock and waits for customers must finance that gap, and the time it takes to pay its suppliers offsets part of it.

Memorize

$$\text{CCC} = \text{DOH} + \text{DSO} - \text{days of payables}$$

A shorter cash conversion cycle means less cash tied up in operations. It can be negative when customers pay before the company pays its suppliers.

Turnover and days are asked from several sides: the days given and the balance or flow wanted. Practice rearranging them.

What about working capital and asset turnover?

They put revenue over a broader base. Working capital turnover uses average working capital (current assets minus current liabilities). Fixed asset turnover uses average net property, plant and equipment, and total asset turnover uses average total assets.

$$\text{Working capital turnover} = \frac{\text{revenue}}{\text{average working capital}}$$

$$\text{Fixed asset turnover} = \frac{\text{revenue}}{\text{average net fixed assets}}$$

$$\text{Total asset turnover} = \frac{\text{revenue}}{\text{average total assets}}$$

For Sandmere, working capital was 1,000 at the start and 1,400 at the end (average 1,200), so working capital turnover is 12,000 ÷ 1,200 = 10.0. Net fixed assets averaged 4,800, so fixed asset turnover is 12,000 ÷ 4,800 = 2.5. Total assets averaged 7,500, so total asset turnover is 12,000 ÷ 7,500 = 1.6.

Total asset turnover matters beyond this lesson: it is the efficiency link in DuPont analysis.

How do you read activity ratios?

Do not stop at “up is good”. Each ratio has a good reading and a warning reading.

• Inventory turnover up (DOH down). Efficient stock management, or stock so thin that sales are lost. Compare with revenue growth.
• DSO up. Lenient credit, collection trouble, or revenue recognized early. Receivables growing faster than revenue is the classic warning.
• Days of payables up. Good use of supplier credit, or a company struggling to pay. Check its liquidity.
• CCC shorter. Less cash tied up. A negative cycle is possible when customers pay before suppliers are paid.
• Low fixed asset turnover. Heavy capital intensity, spare capacity or recently bought assets that have not yet earned their keep.

Go deeper Year-end balances, 360 days and quarterly data

Averages are the default because the flow accrues across the year. When the question wants days of stock at the year-end date, use the ending balance instead (and for a fast-growing business, the last quarter’s COGS). Most questions use 365 days, but some state 360. Quarterly data needs the same period on top and bottom. A turnover computed from one quarter’s COGS, say 2.6, is a rate per quarter: either scale it to a year (about 2.6 × 4 = 10.4) or convert it to days with the quarter’s own length (90 ÷ 2.6 ≈ 34.6 days). Companies on a 52 or 53-week year use the actual days.

Go deeper Negative cash conversion cycles

Subscription, online marketplace and big-box retail models can collect cash from customers before they pay suppliers, so the cycle goes negative and suppliers effectively finance the business. That is a strength when it comes from bargaining power. It is a warning when it comes from payables stretching out because the company cannot pay, especially if inventory is also shrinking because it cannot afford to restock.