What are Efficiency Ratios? Efficiency ratios, also known as activity ratios, measure how effectively a company utilizes its assets and resources, such as capital and assets to generate sales and profits. The ratios serve as a comparison of expenses made to revenues generated, essentially reflecting what kind of return in revenue or profit a company can make from the amount it spends to operate its business.
They help assess operational efficiency, inventory management, and asset utilization, providing insight into how well a company is managing its inventory, receivables, payables and assets. By analysing these ratios, stakeholders can make more informed decisions.
The more efficiently a company is managed and operates, the more likely it is to generate maximum profitability for its owners and shareholders over the long term. A variety of efficiency ratios are examined by financial analysts to make an all-encompassing assessment of a company’s overall operational efficiency as different efficiency ratios focus on different areas of operation.
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There is a strong link between efficiency ratios and profitability: efficient resource allocation typically leads to higher profitability. Thus, improving efficiency ratios over time often suggests that a company is becoming more profitable and can indicate a well-managed company with potential for sustainable growth.
They allow for comparison with peer companies within the industry to assess relative performance. Companies can benchmark their performance against competitors to identify areas for improvement and competitive advantages. Regular analysis of efficiency ratios aids in early detection of issues such as inventory build-ups or slow receivables. Companies can refine their strategies based on insights from these ratios to enhance overall performance.
Key Efficiency Ratios – Examples and their use cases
1. Inventory Turnover Ratio
Formula: Inventory Turnover Ratio = (Cost of Goods Sold (COGS)/Average Inventory)
Uses: Measures how often a company’s inventory is sold and replaced over a period. A higher ratio indicates efficient inventory management.
Example: If a company has a COGS of Rs. 500,000 and an average inventory of Rs. 100,000, the inventory turnover ratio is: (500,000/100,000) = 5.
This means the company turns over its inventory five times a year.
2. Accounts Receivables Turnover Ratio
Formula: AR Turnover Ratio = (Net Credit Sales / Average Accounts Receivables )
Note: Average Accounts Receivables = (Opening Accounts Receivable + Closing Accounts Receivable)/2
Uses: This indicates how efficiently the company is managing its receivables and converting them into cash. A higher ratio suggests better performance in credit management and quicker collection of outstanding invoices.
Example: If Net Credit Sales is Rs. 2,000,000, Opening Accounts Receivable is Rs. 250,000 and Closing Accounts Receivable is Rs. 300,000, the AR Turnover Ratio is: 2,000,000/275,000 ≈ 7.27.
This means that the company collects its average accounts receivable about 7.27 times per year.
3. Accounts Payable Turnover Ratio
Formula: AP Turnover Ratio = ( Net Credit Purchases / Average Accounts Payables)
Note: Average Accounts Payables = (Opening Accounts Payables + Closing Accounts Payables)/2
Uses: This represents the average number of times a company pays off its creditors during an accounting period. The ratio also serves as a measurement of short-term liquidity. A higher payable turnover ratio is favourable as it enables the company to hold cash for a longer time. This, in turn, shrinks the working capital funding gap or working capital cycle.
Example: If Net Credit Purchases is Rs. 1,800,000, Opening Accounts Payable is Rs. 150,000 and Closing Accounts Payable is Rs. 200,000, the AP Turnover Ratio is: 1,800,000/175,000 ≈ 10.29.
This means that the company pays off its average accounts payable about 10.29 times per year.
4. Days Sales Outstanding (DSO)
Formula: DSO = ((Accounts Receivable × Number of Days)/ Total Credit Sales )
Uses: Indicates the average number of days it takes to collect payment after a sale. A lower DSO suggests efficient collection processes.
Example: If accounts receivable is Rs. 150,000, total credit sales are Rs. 1,800,000 and the number of days is 365, the DSO is: 150,000/1,800,000×365 ≈ 30.4 days.
This means it takes about 30.4 days to collect payment.
5. Days Inventory Outstanding (DIO)
Formula: DIO = (Average Inventory × Number of Days) / COGS
Uses: Shows the average number of days inventory is held before it is sold. A lower DIO indicates faster inventory turnover.
Example: If an average inventory is Rs. 100,000, COGS is Rs. 500,000 and the number of days is 365, the DIO is: 100,000/500,000×365=73 days.
This means the company holds inventory for an average of 73 days before selling it.
6. Days Payable Outstanding (DPO)
Formula: DPO = (Accounts Payable × Number of Days) / COGS
Uses: Measures the average number of days a company takes to pay its suppliers. A higher DPO can indicate better cash management but may affect supplier relationships.
Example: If accounts payable is Rs. 80,000, COGS is Rs. 500,000 and the number of days is 365, the DPO is: 80,000/500,000×365≈58.4 days.
This means the company takes an average of 58.4 days to pay its suppliers.
7. Asset Turnover Ratio
Formula: Asset Turnover Ratio = (Net Sales / Average Total Assets)
Uses: Indicates how efficiently a company uses its assets to generate sales. A higher ratio suggests better asset utilization.
Example: If net sales are Rs. 2,000,000 and average total assets are Rs. 1,000,000, the asset turnover ratio is: 2,000,000/1,000,000=2.
This means the company generates Rs. 2 in sales for every Rs. 1 of assets.
How can efficiency ratios benefit a company?
1. Improved Operational Management: By identifying areas where resources are underused or overused, management can make adjustments to improve efficiency. Efficient operations often lead to lower costs and improved profit margins.
For example, a high inventory turnover ratio may reduce storage and holding costs.
2. Enhanced Cash Flow: Ratios like Accounts Receivables Turnover help manage and optimize cash flow by ensuring the timely collection of outstanding payments.
This reduces the risk of cash shortages and improves liquidity. Efficient management of payables, reflected in the Accounts Payables Turnover Ratio can help a company better manage its outflows and take advantage of favourable payment terms.
3. Increased Profitability: High efficiency in utilizing assets such as through a high Asset Turnover Ratio, typically correlates with higher revenue generation. Efficient companies can generate more sales from their assets, leading to improved profitability.
4. Enhanced Competitive Advantage: High-efficiency ratios can attract investors and stakeholders, enhancing the company’s market reputation and potential for growth.
5. Risk Management: Monitoring efficiency ratios can help detect early signs of operational inefficiencies or financial stress. For example, declining turnover ratios might indicate potential issues with inventory management or credit policies, allowing for timely corrective actions.
Wrapping up
As the name suggests, the efficiency ratio tracks the efficiency of any business and helps you learn about enhancing it. It can tell you about attracting investors and stakeholders and enhancing business performance, growth and reputation.
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