Activity and liquidity ratios are key financial metrics used to evaluate an entity’s operational efficiency, asset management, liquidity position, and financial flexibility. Activity ratios assess the entity’s ability to efficiently manage its assets and generate sales, while liquidity ratios measure the entity’s ability to meet its short-term obligations and maintain sufficient cash and liquid assets to support its operations and financial commitments. Here’s an overview of activity ratios and liquidity ratios:

Activity Ratios:

Activity ratios, also known as asset management ratios, evaluate the entity’s efficiency in managing its assets and generating sales, indicating how effectively the entity utilizes its resources to support its operations and generate revenues.

1. Inventory Turnover Ratio:
   • Formula:
     
     $\text{Inventory Turnover Ratio}=\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

      

     Inventory Turnover Ratio=Average InventoryCost of Goods Sold​

   • Interpretation: Measures the efficiency of inventory management and the frequency with which inventory is sold and replaced during a specific period.
2. Accounts Receivable Turnover Ratio:
   • Formula:
     
     $\text{Accounts Receivable Turnover Ratio}=\frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

      

     Accounts Receivable Turnover Ratio=Average Accounts ReceivableNet Credit Sales​

   • Interpretation: Assesses the efficiency of credit management and the frequency with which accounts receivable are collected and converted into cash.
3. Asset Turnover Ratio:
   • Formula:
     
     $\text{Asset Turnover Ratio}=\frac{\text{Net Sales}}{\text{Average Total Assets}}$

      

     Asset Turnover Ratio=Average Total AssetsNet Sales​

   • Interpretation: Evaluates the efficiency of asset utilization and the ability of the entity to generate sales relative to its total assets.

Liquidity Ratios:

Liquidity ratios assess the entity’s ability to meet its short-term obligations and maintain sufficient cash and liquid assets to support its operations, indicating the entity’s liquidity position and financial flexibility.

1. Current Ratio:
   • Formula:
     
     $\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

      

     Current Ratio=Current LiabilitiesCurrent Assets​

   • Interpretation: Measures the entity’s ability to meet its short-term obligations using its current assets, with a higher ratio indicating better liquidity and a lower risk of default.
2. Quick Ratio (Acid-Test Ratio):
   • Formula:
     
     $\text{Quick Ratio}=\frac{\text{Current Assets – Inventory}}{\text{Current Liabilities}}$

      

     Quick Ratio=Current LiabilitiesCurrent Assets – Inventory​

   • Interpretation: Assesses the entity’s ability to meet its short-term obligations using its most liquid assets, excluding inventory, with a higher ratio indicating greater liquidity and a stronger ability to cover immediate liabilities.
3. Cash Ratio:
   • Formula:
     
     $\text{Cash Ratio}=\frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}}$

      

     Cash Ratio=Current LiabilitiesCash and Cash Equivalents​

   • Interpretation: Evaluates the entity’s ability to meet its short-term obligations using its cash and cash equivalents, with a higher ratio indicating superior liquidity and a robust cash position.

activity ratios assess the efficiency of asset utilization and operational performance, focusing on inventory management, accounts receivable collection, and asset turnover. In contrast, liquidity ratios evaluate the entity’s liquidity position and financial flexibility, focusing on its ability to meet short-term obligations, maintain sufficient liquid assets, and manage cash flow risks. By analyzing activity and liquidity ratios, stakeholders can assess the entity’s operational efficiency, asset management practices, liquidity position, and financial health, supporting informed decision-making, planning, and evaluation in a competitive and dynamic business environment.