ACTIVITY OR EFFICIENCY RATIOS

This is the number of times per year that the average amount of receivable is collected.

Amount receivable — debtor. Amount A/C payable — creditor.

It is given by

$$\text{Accounts receivable turnover ratio} = \frac{\text{Net credit sales or net sales}}{\text{Average net accounts receivable}}$$

This ratio provides an indication of how quickly the receivable (debtors) are collected.

Good credit control is an important aspect of sound financial management. The average length of time.

It is given by

$$\text{Debtors average collection period} = \frac{\text{Debtors} \times 365 \text{ days or } 52 \text{ weeks or } 12 \text{ months}}{\text{Credit sales}}$$

Or

$$\frac{365 \text{ days or } 52 \text{ weeks or } 12 \text{ months}}{\text{Accounts receivable turnover}}$$

To put the debtors average collection period in perspective, credit period granted to customers should not be out of line with the credit period granted by suppliers. Good financial management should ensure a proper balance. This ratio indicates the average period measured in terms of months, weeks or days for which creditors remain unpaid.

It is given by

$$\text{Creditors average payment period} = \frac{\text{Creditors} \times 365 \text{ days or } 52 \text{ weeks}}{\text{Credit purchases}}$$

This ratio measures the efficiency with which a company uses its assets to generate sales. That is, it indicates how much a shilling of an asset generates in terms of sales value. The larger the total asset turnover, the larger will be the income on each shilling invested in the assets of the business.

$$\text{Total assets turnover} = \frac{\text{Net sales}}{\text{Average total assets}}$$

It indicates the efficiency of utilization of capital employed in generating revenue.

$$\text{Sales to capital employed} = \frac{\text{Net sales}}{\text{Capital employed}}$$

Under this category, the following ratios can be looked at as equity or longer solvency ratios.

They show the relationship of debt and equity financing in a company. It measures the riskiness of business.

1. Equity or stockholders' equity ratio

It indicates the proportion of total assets that is provided by stockholders (owners) on any given date.

The formula for the equity ratio is

$$\text{Equity ratio} = \frac{\text{Stockholders' equity}}{\text{Total assets}}$$

2. Stockholders' equity to debt ratio

This indicates the measure of the relative proportion of stockholders and creditors.

It is given by

$$\text{Stockholders' equity to debt ratio} = \frac{\text{Stockholders' equity}}{\text{Total debt}}$$

3. Long term debt to shareholders' funds

It indicates the extent of cover for fixed liabilities (loans, debentures).

It is given by

$$\text{Long term debt to shareholders' funds} = \frac{\text{Fixed external liabilities or long term debts}}{\text{Ordinary shareholders' fund}}$$

4. Gearing

This ratio defines the proportion of debt capital and ordinary shares or equity capital. It indicates the degree of vulnerability of earnings available for ordinary shares.

Given by

$$\text{Gearing} = \frac{\text{Fixed interest loans + preference share capital}}{\text{Ordinary share capital}}$$

NB

Some companies use ordinary shareholders' funds as denominator — i.e., ordinary share capital plus reserves — and some use the book value of loans and shares. Usually, a gearing of greater than 1:1 is high and less than 1:1 is low. In practice, greater than 0.6:1 is regarded as high and less than 0.2:1 as low, with the range between these two extremes being regarded as relatively high or relatively low.