Date: 10-January-2018Time: 3:10 PM ~ 4:50 PM
Activity ratios measure a firm's ability to convert different accounts within its balance sheets into cash or sales. Activity ratios measure the relative efficiency of a firm based on its use of its assets, leverage or other such balance sheet items and are important in determining whether a company's management is doing a good enough job of generating revenues and cash from its resources.
BREAKING DOWN 'Activity Ratios'
Companies typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues, so analysts perform fundamental analysis by using common ratios such as the total assets turnover ratio and inventory turnover.
Activity ratios measure the amount of resources invested in a company's collection and inventory management. Because businesses typically operate using materials, inventory and debtors, activity ratios determine how well an organization manages these areas. Activity ratios are one major category in which a ratio may be classified; other ratios may be classified as measurements of liquidity, profitability or leverage.
Activity ratios gauge an organization's operational efficiency and profitability. Activity ratios are most useful when compared to competitor or industry to establish whether an entity's processes are favorable or unfavorable. Activity ratios can form a basis of comparison across multiple reporting periods to determine changes over time.
The following activity ratios may be analyzed as some of an organization's key performance indicators.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio determines an entity's ability to collect money from its customers. Total credit sales are divided by the average accounts receivable balance for a specific period. This activity ratio calculates management's ability to receive cash. A low ratio suggests a deficiency in the collection process.
Merchandise Inventory Turnover Ratio
The merchandise inventory turnover ratio measures how often the inventory balance is sold during an accounting period. The cost of goods sold is divided by the average inventory for a specific period. Higher calculations indicate inventory is quickly converted into sales and cash. A useful way to use this activity ratio is to compare it to previous periods.
Total Assets Turnover Ratio
The total assets turnover ratio take a look at how efficiently an entity uses its assets to make a sale. Total sales are divided by total assets to see how proficient a business is at using its assets. Smaller ratios may indicate that the company is holding higher levels of inventory instead of selling.
What is the 'Efficiency Ratio'
The efficiency ratio is typically used to analyze how well a company uses its assets and liabilities internally. An efficiency ratio can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and machinery. This ratio can also be used to track and analyze the performance of commercial and investment banks.
BREAKING DOWN 'Efficiency Ratio'Analysts use efficiency ratios, also known as activity ratios, to measure the performance of a company's short-term or current performance. All of these ratios use numbers in a company's current assets or current liabilities, quantifying the operations of the business.
An efficiency ratio measures a company's ability to use its assets to generate income. For example, an efficiency ratio often looks at aspects of the company, such as the time it takes to collect cash from customers or the amount of time it takes to convert inventory to cash. This makes efficiency ratios important, because an improvement in the efficiency ratios usually translates to improved profitability.
These ratios can be compared to peers in the same industry and can identify businesses that are better managed relative to the others. Some common efficiency ratios are accounts receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales and stock turnover ratio.
Efficiency Ratios for Banks
The efficiency ratio also applies to banks. For example, a bank efficiency ratio measures a bank's overhead as a percentage of its revenue. Like the efficiency ratios above, this allows analysts to assess the performance of commercial and investment banks.
For a bank, an efficiency ratio is an easy way to measure the ability to turn assets into revenue. Since a bank's operating expenses are in the numerator and its revenue is in the denominator, a lower efficiency ratio means that a bank is operating better. I's believed that a ratio of 50% is the maximum optimal efficiency ratio. If the efficiency ratio increases, it means a bank's expenses are increasing or its revenues are decreasing.
An Example of Efficiency Ratio
For example, Bankwell Financial Group Inc. reported second quarter 2016 earnings on July 27, 2016. The report stated that the financial group had an efficiency ratio of 57.1%, which was lower than the 63.2% ratio it reported for the same quarter in 2015. This means the company's operations became more efficient; it increased its assets by $80 million for the quarter.
What is a 'Financial Crisis'
A financial crisis is a situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.
BREAKING DOWN 'Financial Crisis'
A financial crisis can occur as a result of institutions or assets being overvalued, and it can be exacerbated by irrational investor behavior. A rapid string of selloffs can further result in lower asset prices or more savings withdrawals. If left unchecked, the crisis can cause the economy to go into a recessionor depression.
How the 2008 Financial Crisis Happened
The 2008 financial crisis was the worst economic disaster since the Great Depression of 1929. The root cause has been traced to no one single event or reason. Rather, it was the result of a sequence of events, each with its own triggering mechanism that led to near collapse of the banking system. It has been argued that the seeds of the crisis were sown as far back as the 1970s with Community Development Act, which forced banks to loosen their credit requirements for lower-income minorities, creating a market for subprime mortgages.
The amount of subprime mortgage debt, which was guaranteed by Freddie Mac and Fannie Mae, continued to expand into the early 2000s, about the time the Federal Reserve Board began to cut interest rates drastically to fend off a recession. The combination of loose credit requirements and cheap money spurred a housing boom, which drove speculation, which in turn drove up housing prices.
In the meantime, the investment banks, looking for easy profits in the wake of the dotcom bust and 2001 recession, created collateralized debt obligations (CDOs) out of mortgages purchased on the secondary market. Because subprime mortgages were bundled with prime mortgages, there was no way for investors to understand the risks associated with the product. Around the time when the market for CDOs was heating up, the housing bubble that had been building up for several years was beginning to burst. As housing prices fell, subprime borrowers began to default on loans that were worth more than their homes, accelerating the decline in prices.
When investors realized the CDOs were becoming worthless due to the toxic debt they represented, they tried to unload them, but there was no market for them. This caused a cascade of subprime lender failures, which created a liquidity contagion that worked its way to the upper tiers of the banking system. Two major investment banks, Lehman Brothers and Bear Stearns, collapsed under the weight of their exposure to the subprime debt, and more than 450 banks failed over the next five years. Several of the major banks were on the brink of failure had it not been for a taxpayer-funded bailout.