Efficiency Ratio

What is the efficiency ratio?

Efficiency ratios indicate the ability of a business to use its assets and liabilities for generating sales. An organization that is highly efficient would have minimized its net investment in assets. This implies that it requires less debt and capital in order to continue its operations. This ratio usually compares an aggregated set of assets to sales or the cost of sold goods.  

In the case of liabilities, the ratio compares payables to total purchases from suppliers. For evaluating the performance, these ratios are compared to the results of other companies operating within the same industry. Also known as activity ratios, efficiency ratios in general convert inventory into cash. The management can utilize these ratios in improving the company while the creditors and investors can study the profitability of the company looking into efficiency ratios.  

Key Takeaways:

• Efficiency ratios measure the ability of the company to utilize its assets and manage its liabilities effectively.
• These ratios measure the time taken to generate income from a client or by liquidating any inventory. It also indicates the ability of a company to meet its long term and short term debt obligations. If a company cannot get paid on time, then it cannot repay its debt on time. 
• Efficiency ratios compare who well a company uses its assets for generating revenues.

Types of efficiency ratio:

There are different efficiency ratios that help you judge the performance of a company. The following are the kinds of efficiency ratios commonly used in the industry.

• Accounts Receivable Turnover:

This ratio measures the number of times the management can collect money from its customers to whom it renders its service or sells goods. It conveys how quickly a company makes sales. This ratio is an indicator of how efficient the credit policies of the company are and the level of investment it makes in receivables to sustain the sales level.  

Here is the formula used for the calculation of Accounts receivable turnover. 

Accounts Receivables Ratio = Net Sales  / Average Accounts Receivables

Deducting the number of goods returned back from the total sales provides Net Sales for a company. 

Net Sales = Sales - Returns

Average accounts receivable is estimated by taking an average of the current year accounts receivable and the previous year accounts receivable for a company. 

Average Accounts Receivables = (Current Year AR + Previous Year AR) / 2

If the accounts receivables turnover ratio is high, then it implies that the management can easily collect money from its customers and can efficiently manage its debt obligations. 

• Inventory Turnover Ratio:

This ratio measures the number of times management is able to sell off its inventory. The higher the ratio, the more is the number of times the management is easily able to turn its inventory into cash. 

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory 

Cost of Goods Sold = Opening Stock + Purchases - Closing Stock

Average Inventory = (Current year inventory + Previous year inventory)  / 2

The higher is this ratio, the more efficient is the management of a company.  For instance, if the Inventory Turnover Ratio is 10 for a company, then it implies that the management is able to convert its inventory into cash 10 times in a year. A lower ratio indicates that the company is not able to manage its inventory well and maybe facing overstocking issues.  

• Fixed Asset Turnover:

This efficiency ratio formula involves dividing sales by average fixed assets. A high ratio can be achieved by outsourcing asset-intensive production to suppliers, by maintaining high equipment utilization levels, and by avoiding investing in excessively high equipment that offers little value. It provides an idea about how much a company needs to invest to generate a sale. Analysts measure the operating efficiency of a company using this ratio.  

Fixed Asset Turnover = Net sales / Average Fixed Assets

• Total Asset Turnover Ratio:

This efficiency ratio calculation indicates how efficiently management is using both its long term and short term assets. The higher is the ratio; the better is the company's performance. A higher ratio indicates that the company is generating more revenue per rupee of assets.   

Total Asset Turnover = Net sales / Average Total Assets

Efficiency ratio calculation:

Here is an example of Alpha Inc. we have taken in estimating and analyzing the efficiency ratio. 

Total Asset Turnover=8,00,000 / 2,50,000 = 3.2

Inventory Turnover Ratio = 6,25,000 / 1,11,000 =5.63 

We have estimated total asset turnover and inventory turnover ratio as per the data available. A Total Asset Turnover ratio of 3.2 indicates that the assets generated are three times more than their value in sales for the concerned period.  The inventory turnover ratio indicates that Alpha Inc. is turning its inventory 5 times per year. The higher is the ratio, the better it is for any company as it indicates that the company is efficient in generating its revenues. 

Efficiency ratio analysis and interpretation:

Efficiency ratios are used for judging how efficient the management of a company is. If the efficiency ratio is high, then it indicates that the management is effective in utilizing the minimum amount of assets in relation to its given amount of sales. A low ratio implies that the payables are being stretched. 

Performing efficiency ratio analysis by the management can have negative impacts on business. For instance, a low rate of liability turnover could be linked to deliberate payment delays which could result in the company being denied credit from its suppliers. Also, the desire to achieve a high-efficiency ratio could compel management to cut back necessary investments in fixed assets or in stocking finished goods in low volumes that the deliveries to the customers could get delayed.  

In summary:

Efficiency ratios are crucial for evaluating the operations of a business. An investor can make the right investment decision by studying efficiency ratios. It also helps in understanding if a company has been performing well or not in its sector by comparing it with other industries in the same segment.