Financial Statement Analysis-FIN621
Activity Ratios also known as efficiency or turn over ratios, measure how effectively the firm is
using its assets. Some aspects of activity analysis are closely related to liquidity analysis. Our
focus is to attention on how effectively the firm is managing two specific asset groups-
receivables and inventories- and its total assets in general.
Working capital: It depends upon the size and nature of business. Arithmetically it is
the difference of Current Assets and Current Liabilities. Two companies with same
working capital can have different current ratios. Similarly two companies may have
same current ratio but different working capital.
Quality of Working Capital:
(A) Liquidity of inventory:
To help determined how effectively the firm is managing inventory (and also to gain an
indication of the liquidity of inventory) we compute the inventory turn over ratio. This ratio,
like other ratios, must be judged in relation to ratios of similar firms, the industry average or
Generally the higher the inventory turn-over , the more efficient the inventory management of
the firm and the "fresher" more liquid, the inventory and vice versa.
It shows how quickly inventory is sold and is determined by Inventory Turnover Ratio
(ITO). It is the number of times the company sells (turns over) it inventory during the year.
Inventory Turnover Ratio (ITO) = Cost of good sold for the year____
= 60 = 3
Average inventory during the year
The higher the rate, the more quickly the company sells its inventory. However, companies selling high
markup items e.g. Jewelry Stores, F-16 can operate successfully with much lower ITO.
Days required to sell inventory: i.e.
Converting inventory into Receivables = 365 or 300 = 365 or 300 = 122 or 100
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