The financial reasons for activity make it possible to know to what extent a company uses its resources; When an analyst wants to determine how well a firm allocates its resources, it compares these reasons to industry standards. They are also called asset management ratios because they indicate how well an organization works in relation to how it manages its assets in the short and long term.
These indicators, also known as efficiency indices, relate the balance sheet (assets) to the income statement (sales), that is, they show the ability of the company to use its assets to generate sales. According to Moyer et al. (p.74): If it is possible to achieve an appropriate mix of cash, accounts receivable, inventories, plants, real estate and equipment, the company's asset structure will be more effective in generating sales revenue.
What is activity
Basic budget category that brings together actions that contribute to the operation and maintenance of existing public or administrative services. Represents the production of goods and services that the entity carries out in accordance with its competences within current processes and technologies. It is permanent and continuous over time and responds to objectives that can be measured qualitatively or quantitatively through its components and goals. (Blas, p.33)
What is efficiency
Efficiency is the ability to make the best possible use of the means available to achieve a desired result. A company is said to be efficient when it achieves maximum production by fully utilizing available investments or inputs. (Spencer, p.15)
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Activity or efficiency reasons
The financial ratios of activity or efficiency measure the speed with which various accounts are converted to sales or cash, that is, to entries or exits. (Gitman and Zutter, p. 68). Activity ratios allow the financial analyst to answer, among others, the following questions: How effective is the company in converting its inventories into finished products? How long does it take the firm to collect its debts? How long does it take the company to pay what it owes? Or what is the capacity of an organization to generate resources from its assets?
The activity indices that are most frequently used in financial analysis are:
Inventory rotation
It is an indicator of the inventory activity of a company, that is, it indicates how many times the total stock has been renewed in a given time and is calculated as follows:
The resulting turnover is meaningful only when compared to that of other companies in the same industry or to the past turnover of the firm's inventories. (Gitman and Zutter, p.118)
Many believe that the higher a company's inventory turnover, the more efficient its inventory is managed. This is true up to a point, after which high inventory turnover can cause problems. For example, one way to increase inventory turnover is to keep inventory low. However, such a strategy could lead to a large number of inventory shortages, resulting in insufficient sales losses, which in turn can harm the company's future sales. In each industry there is a range to inventory turnover that may be considered convenient. Values below this range may indicate illiquidity or inactive inventories, while values above this limit may indicate insufficient inventories. (González, p.50)
A procedure to calculate the essential stocks for the normal operation of the company - the useful stock - is the one that consists of dividing the cost of sales for the year by the average index of its turnover in previous years. The value of the normal stock thus obtained and its comparison with the actual stock makes it possible to detect whether it is normal, insufficient or excessive. (Rubio, p.44)
Some authors consider that the inventory turnover, which appears on the annualized balance sheet, should not be considered for calculating inventory turnover, but rather an average inventory should be used which, following Moyer et al. (p.75), it can be calculated in various ways; for example, if a company has been experiencing significant and continuous growth in sales rhythm, the average inventory could be calculated by adding the initial and final inventory figures during the year and dividing it by two. However, if sales are seasonal or subject to wide fluctuations, it would be best to add the month-end inventory balances for the entire year and divide by twelve.
The inventory turnover has the possibility of being translated into another activity ratio known as the average age of the inventory, also called inventory in days, which shows the average number of days required to sell the inventory and is calculated as follows:
365 = number of days of the year
Average collection period
It is the average number of days that an account receivable remains unpaid, in other words, it represents the average period of time that a company must wait to receive cash after making a sale and is meaningful only when related to credit conditions of the company. It is calculated as follows:
Moyer et al. (p.75) expose that for the financial analysis of the company, in general, an average collection period that is substantially above the normal in the sector is not desirable, since it could indicate a too liberal credit policy. Ultimately, company managers must determine if the liberal credit policy increases sales and profits enough to justify the increase in cost. In contrast, an average recovery period well below normal for the sector could indicate that the company's credit terms are too strict and that they harm sales by limiting credit to only the best clients. While slow to moderate paying customers may seem problematic on an individual basis, they may be profitable as a group,and too strict a credit policy could lead them to competing companies.
Another point of view of the average collection period is the rotation of accounts receivable whose ratio is presented below:
Gonzáles (p.51) points out that the higher the turnover of the company's accounts receivable, the more favorable it is. A company can increase the turnover of its accounts receivable with a very restrictive credit policy, but this strategy is not recommended because it could produce sales losses. The financial analyst should especially question very high account receivable rotations because this may be indicative of a poor credit policy.
You should read: What are the financial reasons for profitability?
Average payment period
Indicates the average time the organization requires to pay its bills.
Wild et al. (p.434) declare that current operating assets, such as inventories, are largely financed with accounts payable. Such accounts payable generally represent interest-free financing and are therefore less expensive than using borrowed money to finance inventory or production purchases. Consequently, companies use business credit whenever possible. This is called leaning on providers.
The ratio analogous to the average collection period is the so-called turnover ratio of accounts payable which is calculated as follows:
Continuing with Wild et al. (p.434), like inventories, accounts payable are stated at cost and not at retail prices. Thus, for purposes of consistency with the denominator, the cost of goods sold (not sales) is used in the numerator. If other factors are not involved, companies prefer to use this cheap source of financing as much as possible, and therefore have a lower rate of accounts payable turnover (implying a higher level of accounts payable). To lower the turnover ratio of accounts payable, payment to suppliers is delayed, and this delay in payment damages relations with the supplier if used excessively. Therefore, accounts payable must be managed carefully.
A low turnover rate of accounts payable corresponds to a high average payment period.
You should read: What are the financial liquidity ratios?
Rotation of total assets
It indicates whether the company's operations have been financially efficient, in other words, it shows the efficiency with which the firm uses all its resources to generate sales and is calculated as follows:
Vaquerano (p.66) explains that the result of this index provides information to the financial analyst and other people interested in knowing the financial situation of the company, about the level of relative efficiency with which the company uses its resources in order to generate the production. It should be noted that the value or result provided by this ratio will vary depending on the type of company being studied. Thus, for example, a supermarket will have a much higher turnover of its products compared to a company that produces and markets household appliances. It should also be noted that the turnover ratio of total assets is a function of the product of the efficiency with which it is they manage the various components of total business assets; that is to say: a.The efficiency in the management of accounts receivable, as shown by the average collection period. b. Inventory management efficiency, as indicated by inventory turnover. c. The efficiency in the rotation of fixed assets, as indicated by the flow of production through the plant or the ratio of sales to net fixed assets.
You should read: What are the financial reasons for indebtedness?
To complement your learning process, we leave you with Professor Einar Moreno from the University of the Americas, Puebla, who explains, in the following video-lesson, the topic of the financial reasons for activity, how they are obtained and why it is important to use them as indicators within the financial analysis.
Bibliography
- Blas Jiménez, Pedro E., Dictionary of Administration and Finance. Ed. Palibrio, 2014.Gitman, JL and Zutter, CJ Principles of financial management. Pearson Education, 2012.Gonzáles Urbina, Pedro. Analysis and interpretation of financial statements. Editorial Printing Union of the Universidad Peruana Unión, 2013.Moyer, CR, McGuigan JR and Kretlow WJ Contemporary Financial Administration. International Thomson Editores, 1999. Rubio Domínguez, P.: (2007) Financial Analysis Manual, Free electronic edition. Full text at www.eumed.net/libros/2007a/255/Spencer, Milton H. Contemporary economy. Ed. Reverté, 1993. Van Horne, James C. Financial Administration. Pearson Education, 2002. Vaquerano Amaya, José Adán. Fundamental material of financial analysis. Universidad Centroamericana José Simeón Cañas, 2007. Wild, John J.,Subramanyam, KR and Halse, Robert F. Analysis of financial statements. McGraw-Hill Interamericana Editores, 2007.
