TURNOVER RATIO OR ACTIVITY RATIO or ASSET MANAGEMENT RATIO
Turnover ratios are also known as activity ratios or efficiency ratios with which a firm manages its current assets. The following turnover ratios can be calculated to judge the effectiveness of asset use.
- Inventory Turnover Ratio
- Debtor Turnover Ratio
- Creditor Turnover Ratio
- Assets Turnover Ratio
1. INVENTORY TURNOVER RATIO
This ratio indicates whether investment in stock is efficiently used or not, in other words, the number of times the inventory has been converted into sales during the period. Thus it evaluates the efficiency of the firm in managing its inventory. It helps the financial manager to evaluate the inventory policy. It is calculated by dividing the cost of goods sold by average inventory.
- Inventory Turnover Ratio = Cost of goods sold / Average Inventory (or)
- Net Sales / Average Stock
- Cost of goods sold = Sales-Gross profit
- Average Stock =Opening stock + Closing stock/2
2. DEBTOR TURNOVER RATIO
Debtors play a vital role in current assets and to a great extent determines the liquidity of a firm. This indicates the number of times average debtors have been converted into cash during a year. It is determined by dividing the net credit sales by average debtors.
- Debtor Turnover Ratio = Net Credit Sales / Average Trade Debtors (or)
- Net Credit Sales / Average Debtors – Average Bills Receivable
- Net credit sales = Total sales – (Cash sales + Sales return)
- Total debtors = [ Op.Dr. + Cl.Dr. / 2 + Op.B/R + Cl. B/R / 2]
When the information about credit sales, opening and closing balances of trade debtors is not available then the ratio can be calculated by dividing total sales by closing balances of trade debtor
Debtor Turnover Ratio = Total Sales / Trade Debtors
Note: Bad and doubtful doubts and their provisions are not deducted from the total debtors. The higher ratio indicates that debts are being collected promptly.
3. CREDITOR TURNOVER RATIO
This is also known as “Creditors Velocity”. It indicates the number of times sundry creditors have been paid during a year. It is calculated to judge the requirements of cash for paying sundry creditors. It is calculated by dividing the net credit purchases by average creditors.
- Creditor Turnover Ratio = Net Credit Purchases / Average Trade Creditor (or)
- Net Credit Purchases / Average Creditors + Average Bills Payable
- Net credit purchases = Total purchases – (Cash purchase + Purchase return)
- Total Creditors = [Op.Cr. + Cl.Cr. / 2 + Op. B/P + Cl. B/P / 2]
The higher ratio should indicate that the payments are made promptly. Net credit purchases consist of gross credit purchases minus purchase return.
When the information about credit purchases, opening and closing balances of trade creditors is not available then the ratio is calculated by dividing total purchases by the closing balance of trade creditors.
Creditor Turnover Ratio = Total purchases / Total Trade Creditors
4. ASSETS TURNOVER RATIO
The relationship between assets and sales is known as assets turnover ratio. Several assets turnover ratios can be calculated depending upon the groups of assets, which are related to sales.
a) Total asset turnover.
b) Net asset turnover
c) Fixed asset turnover
d) Current asset turnover
e) Net working capital turnover ratio
a. TOTAL ASSET TURNOVER
This ratio shows the firms ability to generate sales from all financial resources committed to total assets. It is calculated by dividing sales by total assets.
Total asset turnover = Total Sales / Total Assets
b. NET ASSET TURNOVER
This is calculated by dividing sales by net assets.
Net asset turnover =Total Sales / Net Assets
Net assets represent total assets minus current liabilities. Intangible and fictitious assets like goodwill, patents, accumulated losses, deferred expenditure may be excluded for calculating the net asset turnover.
c. FIXED ASSET TURNOVER
This ratio is calculated by dividing sales by net fixed assets.
Fixed asset turnover = Total Sales /Net Fixed Assets
Net fixed assets represent the cost of fixed assets minus depreciation.
d. CURRENT ASSET TURNOVER
It is divided by calculating sales by current assets
Current asset turnover = Total Sales / Current Assets
e. NET WORKING CAPITAL TURNOVER RATIO
A higher ratio is an indicator of better utilization of current assets and working capital and vice-versa (a lower ratio is an indicator of poor utilization of current assets and working capital). It is calculated by dividing sales by working capital.
Net working capital turnover ratio = Total Sales / Working Capital
Working capital is represented by the difference between current assets and current liabilities.
Strategic Management Notes 