Financial ratios tend to provide a relative measure of short-term or long-term performance. The terms of trade, for example, measure the ratio of export price to import price. The efficiency ratio estimates trade benefits by measuring the number of imports per export.
These profitable ratios assess the company’s performance concerning its asset usage. It gives an idea about the assets or current liabilities that the company is using to reap benefits.
Defining an Efficiency Ratio: What is a Good Efficiency Ratio?
A company balances its assets and liabilities effectively to maximize its profits. However, they need some metrics to calculate the ability of their assets to generate income.
The asset turnover ratio, for example, measures the ratio of net sales to its total assets. Thus, a higher asset turnover ratio indicates a healthy sales-generating capacity. However, a lower value denotes that a company might suffer from internal problems and find utilizing its assets challenging.
Analysts do not concentrate their interest on individual sales or revenue figures. Instead, they turn to financial ratios to understand the correlation between these statistics and the company’s profitability.
Types of Efficiency Ratios in Financial Analysis
Efficiency ratios provide a proper understanding of a company’s financial health. Inputs on the balance sheet, like real estate holdings, current inventory, and machinery, add to its value.
Thus, institutions like banks use these ratios to understand their annual financial performance. For banks, however, a lower ratio indicates higher revenue than expenses which implies that they are operating well. Optimal profitable ratios for banks mean 50% or below the efficiency ratio.
Here are a few primary financial ratios that define a company’s performance:
- Inventory turnover ratio
- Total assets turnover ratio
- Accounts receivable turnover ratio
- Accounts payable turnover ratio
- Working capital turnover ratio
- Fixed assets turnover ratio
- Debt to equity ratio.
The following section discusses the financial ratios in detail and how an operating efficiency ratio affects a company’s performance.
Inventory Turnover Ratio (ITR)
Inventory Turnover Ratio (ITR) is the rate at which a company replaces its inventory in a specified time. The inventory turnover ratio helps companies identify their sales figures, review their pricing strategies and make purchasing decisions. A well-managed inventory indicates that their sales figures meet their targets.
The formula for calculating the inventory turnover ratio is as follows:
Inventory turnover ratio = Cost of goods sold / Average inventory.
Here are the benefits of calculating ITR:
- A high inventory turnover guarantees better operational efficiency and overall financial stability. So if a company’s sales figures are rising, it indicates that the inventory needs to be replenished very often. Consequently, lower ITR might show a decline in sales because of diminished demand.
- Low ITR might imply over-estimation of demand. Conversely, higher ITR means that the company’s sales are fast, keeping up with their projected demand.
- It’s synonymous with consumer theory where investment should equal savings. In an ideal situation, inventory should match sales. Holding on to inventories that do not create sales impact is meaningless and is not cost-effective. Thus a healthy ITR indicates that sales figures align with the inventory figures.
Asset Turnover Ratio
Synonymous to other financial ratios, this capital efficiency ratio suggests that the company is efficient in managing inventory to generate revenue. Effectively, it is simply the ratio between the total sales revenue and the net assets that the company owns.
Typically, a higher ATR ratio indicates that the company can successfully generate more revenue from its existing assets. In addition, since labour is the only variable factor in short-run production, higher ATR may imply that the company is generating favorable revenue figures from its existing workforce.
Asset turnover ratio = Total sales / [(Opening stock + Closing stock)/2]
A lower ATR indicates that the company’s surplus production units cannot cope with the sales figures. Generally, ATRs are calculated for organizations belonging to the same sector. Service sector industries, for example, have a small asset base with larger sales volumes. Manufacturing firms, however, generally have a more extensive asset base, thus implying lower asset turnover.
Receivables Turnover Ratio
When a company extends credit to its customers, it aims to get over this liability rapidly. RTR calculates the rate at which short-term debt is paid off. Like other efficiency ratios, it measures the company’s operating efficiency in collecting its accounts receivable.
ATR = Net credit sales / Average accounts receivable
Here, net credit sales refer to cash received at a later date.
Average accounts receivable = (Opening accounts receivable + Closing accounts receivable)/2
RTR estimates the company’s financial and operational performance. Thus, higher RTR indicates that cash collection is recurrent and efficient at later dates. Plus, it implies that the company’s customers are reliable and they can pay off their debts in time. In the long run, it can indicate a conservative credit policy.
Lower RTR values indicate poor performance in terms of credit collection. This means that the company has non-creditworthy customers. It can also tell that the company is extending its credit policy over a more extended period, thus aiming to generate more significant sales.
Accounts Payable Turnover Ratio
The APTR determines how companies pay off their suppliers. Accounts payable refers to a company’s short-term debt, and thus, this ratio denotes the efficacy of such transactions.
APTR gives an insight into the payback capabilities of a company. An increasing APTR indicates that the company is paying off its debts fast and has enough funds to manage its cash flow effectively.
APTR = Total supply purchases / [(Opening accounts payable + Closing accounts payable)/2]
Days Sales of inventory
It represents the average number of days a company requires to turn its inventory into sales. Sometimes known as the average age of inventory, it calculates the inventory liquidity to show how many days the current inventory will last.
DSI measures the sales potential; a high DSI indicates improper inventory management. This efficiency ratio formula is mentioned below:
DSI = Average inventory/Cost of goods sold x 365.
Financial ratios, in general, provide companies with a genuine understanding of their statistics and their representation. Likewise, DSI deals with inventory and the operational capital requirements of the company. It measures the amount of inventory stuck in the inventory. Manufacturing and automobile companies have different values of DSI since they need to hold on to their assets for a long duration. The key is to balance inventory levels and demand for goods.
Bank Efficiency Ratio
Banks’ profitability depends on their net assets and how they utilize that to create revenue. Therefore, the efficacy of their asset utilization depends on the ratio of their operating expenses to income generated. Bank efficiency ratio essentially discloses this volatile metric in their financial statements.
The formula for bank efficiency ratio is as follows:
BER = Non-interest expense / (Net interest income + Non-interest income – Provision for credit losses like NPA).
Ideally, banks aim to keep their BER at 50%. In this optimal situation, banks can project their net expenses and income. Lower BER indicates that the bank is performing better since its primary aim is to lower its costs.
Thus, if SBI reported an efficiency ratio of 57% in FY 2021-2022 instead of 67% in FY 2020-21, it indicates an improvement in operations.
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Final Word
Efficiency ratios effectively determine the current financial position of a company and outline the necessary changes required. Changes may include lowering expenses, periodically replenishing inventory, collecting credit, etc.
Frequently Asked Question
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What is a significant financial ratio for advertising agencies to track?
The performance of advertising businesses can be tracked using revenue per head as an important metric. It measures the individual contributions and helps determine if they require future hiring.
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How do use the financial ratios to determine performance?
Financial ratios help analyze a company’s financial statements and understand them for improvement. In addition, they help judge efficacy and compare performance between companies from the same sector.
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What are some limitations of financial ratio analysis?
There is often a fragile line between a good and bad ratio. Plus, financial ratios are not independent. Hence they are sometimes misleading and do not consider the effects of economic shocks like inflation.
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