Efficiency Ratios – Definition, Formula, and Uses

There are several different types of efficiency ratios. Each one assesses a different aspect of a company’s operation. Some of the most common efficiency ratios include:

1. Inventory Turnover Ratio: The inventory turnover ratio assesses how efficiently a company manages its inventory. It measures how many times a company’s inventory is sold, used, or replaced over a given period (e.g., a month, quarter, or year). A high ratio can indicate a company is experiencing strong sales while a low ratio can indicate the demand for a company’s products are low.

The inventory turnover ratio for product-based or manufacturing companies is calculated by dividing the cost of the goods sold by the average inventory for the same period.

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average value of inventory

Where:

• Cost of goods sold = The direct costs associated with producing a good, including material costs, direct labour costs, and direct factory overheads.
  
• Inventory = The cost of all raw materials, work-in-progress, and finished goods that a company has accumulated.
• Average value of inventory is calculated by adding the value of inventory at the end of a period to the value of inventory at the end of the prior period and dividing the sum by 2.

2. Accounts Receivable Turnover Ratio: Also known as the receivables turnover ratio or debtor’s turnover ratio, the accounts receivable turnover ratio measures how efficiently a company collects its revenue. It tells investors how many times a company collected its average accounts receivable during a given period. The higher the ratio, the better the business is at managing customer credit. The ratio is calculated by the following equation:

Accounts Receivable Turnover Ratio = Net credit sales / Average accounts receivable

Where:

• Net credit sales = Sales on credit – Sale returns – Sales allowances.
  
• Average accounts receivable = The sum of starting and ending accounts receivable balances over the selected period / 2.

3. Accounts Payable Turnover Ratio: The accounts payable turnover ratio measures how quickly a company pays its creditors and suppliers. It calculates the average number of times a company pays its account payable balances over a specified period. While a healthy payable turnover rate varies by industry, a high ratio implies that company is well placed to pay-off its short-term financial obligations.

Accounts Payable Turnover Ratio = Net credit purchases / Average accounts payable

Where:

• Net credit purchases = Cost of Goods Sold (COGS) + Ending inventory balance – Starting inventory balance for the specified period.
  
• Average accounts payable = The sum of starting and ending accounts payable balances for the specified period / 2.

4. Asset Turnover Ratio: The asset turnover ratio measures how efficiently a company uses its assets to generate revenue. It’s calculated by dividing a company’s net sales by the average total assets. A high asset turnover ratio is considered to be favorable.

Asset Turnover Ratio = Net sales / Average total assets

Where:

• Net sales = Sales – Sale returns, sales discounts, and sales allowances
• Average total assets = (Total assets at the end of the period + Total assets at the beginning of the period) / 2

5. Operating Expense Ratio: The operating expense ratio measures how efficiently a company manages its expenses. It compares the cost of operating a property with the income that property generates. Investors use it to compare the relative profitability of different properties. A high operating expense ratio may indicate that a company’s expenses are too high and that it may not be operating as efficiently as possible.

Operating Expense Ratio = Operating expenses / Total gross income or revenue.

Operating expenses can vary, but typically include insurance, taxes, maintenance, and utilities.

Gross revenue, also called gross income, refers to the total money generated by a business from all sources, less all expenses (paid or due).

Investors use efficiency ratios to analyze how well a company is managed and how efficiently it operates. There’s typically a strong correlation between the quality of a company’s management, the efficiency of its operations, and its profitability. Improvement in a company’s efficiency ratio over time can indicate its operations are improving and are becoming more profitable.

Efficiency ratios can help investors compare the efficiency, and potential profitability, of companies operating within the same sector or industry. Companies with an efficiency ratio that’s above industry benchmark are considered to be better run, and more likely to generate a profit, than their peers.

While you can use the efficiency ratio to assess a company’s profitability, it has some limitations.

• Effects of inflation: Changes in inflation can affect a company’s profitability. That can make it hard to use efficiency ratios to compare a company’s performance over long periods of time.
• Seasonal influences: Efficiency ratios will change at different points of the year. Some companies, like retailers, may invest heavily in inventory at one part of the year in preparation for peak sales periods down the road.
• Different accounting practices: Accounting practices can vary between companies. That can make it hard to make direct comparisons between different companies.
• Some companies, like large conglomerates, operate in more than one sector. That can make it hard to obtain clear data for use in comparing them with their competitors.