Activity Ratios

For Aldine, whose inventory turnover we calculated to be 2.02, the inventory turnover in days (ITD) is This figure tells us how many days, on average, before inventory is turned into accounts receivable through sales. Transforming the industry's median inventor)' turnover of 3.3 into an inventor)' turnover in days figure, we get 365/3.3 = 111 days. Thus Aldine is, on average, 70 days slower in "turning" its inventory than is typical for the industry.

Operating Cycle versus Cash Cycle. A direct result of our interest in both liquidity and activity ratios is the concept of a firm's operating cycle. A firm's operating cycle is the length of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or services. It is as if we start a stopwatch when we purchase raw materials and stop the watch only when we receive cash after the finished goods have beer sold. The time appearing on our watch (usually in days) is the firm's operating cycle.

We stress the fact that our stopwatch starts at the commitment of cash for purchases rathe: than from the actual cash outlay itself. The reason for this subtle distinction is that most firms do not pay for raw materials immediately but rather buy on credit and incur an account payable. However, if we want to measure the length of time from the actual outlay of cash for purchases until the collection of cash resulting from sales, it is a simple matter.

Why even worn' about the firm's operating cycle? The length of the operating cycle is an important factor in determining a firm's current asset needs. A firm with a very short operating cycle can operate effectively with a relatively small amount of current assets and relativeh Inventory turnover Receivable turnover in days (ITD) + in days (RTD).

low current and acid-test ratios. This firm is relatively liquid in a "dynamic" sense - it can produce a product, sell it, and collect cash for it, all in a relatively short period of time. It does not have to rely so heavily on high "static" levels of liquidity as measured by the current or acid-test ratio. This is very similar to judging the "liquidity" of a garden hose. This liquidity depends not only on the "static" amount of water in the hose at any one time but also the velocity with which the water moves through the hose.

The operating cycle, by focusing on ITD and RTD, provides a summary activity measure. For example, a relatively short operating cycle generally indicates effectively managed receivables and inventory. But, as we have just discussed, this measure provides supplementary information on a firm's liquidity as well. A relatively short operating cycle would thus also reflect favorably on a firm's liquidity. In contrast, a relatively long operating cycle might be a warning sign of excessive receivables and/or inventor)', and would reflect negatively on the firm's true liquidity.

The cumulative effect of both a sluggish inventor)' turnover and receivable turnover for Aldine is clearly apparent; relative to the typical firm in the industry, it takes Aldine an extra 87 days to manufacture a product, sell it, and collect cash from sales. The length of the firm's operating cycle should also cause us to to have second thoughts about the firm's liquidity. We have not said very much, so far, about the firm's cash cycle. One reason is that one must be extremely careful in trying to analyze this measure. On the surface, it would seem that a relatively short cash cycle would be a sign of good management. Such a firm is quick to collect cash from sales once it pays for purchases. The catch is that this measure reflects both operating and financing decisions of the firm, and mismanagement in one or both of these decision areas might be overlooked. For example, one way to arrive at a short cash cycle is simply never to pay your bills on time (a poor financing decision). Your payable turnover in days figure will become large, and subtracted from your operating cycle, it will produce a low (perhaps even negative!) cash cycle. The operating cycle, by focusing strictly on the effects of operating decisions on inventor)' and receivables, provides clearer signals for the analyst to consider.