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Are you starting your stock market journey? As an investor, when analysing a company you often look at various aspects of the company, including its fundamentals, different ratios and comparing it with its competitors.
But is that enough in today’s cutthroat business world? As investors, you might want to look for companies which are more efficient, i.e, how they use their resources to generate revenue. Here efficiency ratios come into play.
Let’s look at what the efficiency ratio is and what is the importance of efficiency ratio.
What is the efficiency ratio?
Efficiency ratios are financial indicators that analyse how a company utilises its assets and liabilities, known as resources, to maximise its income and profits. These ratios highlight the company’s proficiency in managing costs and maximising the yield from its resources.
An efficiency ratio is particularly useful for gauging the extent to which a company’s expenditures translate into revenue. In essence, they provide insight into the revenue or profit returns a company achieves relative to its operational expenditures.
Types of efficiency ratio
Here are some commonly used efficiency ratios:
- Inventory turnover ratio: It determines how often a company sells off and restocks its inventory over time. A high figure denotes effective inventory control and robust sales. A lower number suggests too much unsold inventory.
- Asset turnover ratio: This assesses how effectively a business generates revenue from sales using its assets. A higher ratio means the company is utilising its assets effectively to produce revenue.
- Accounts receivable turnover ratio: This shows the speed with which a business receives payments from clients. A higher rate indicates faster receivables collection for the business, which enhances cash flow.
- Accounts payable turnover ratio: This quantifies how frequently a business reimburses its vendors. A higher ratio may mean the company is managing cash flow efficiently by paying suppliers promptly.
- Days sales in inventory (DSI): The relationship between time and inventory turnover ratio is inverse. Rather than showing the number of times inventory is sold over time by a company, DSI calculates the average number of days it requires to sell its inventory. More effective inventory management is suggested by a lower DSI.
How to calculate efficiency ratio?
Here are some efficiency ratio formula:
- Inventory turnover ratio
Inventory
Where
- Cost of goods sold (COGS) is the total cost to produce the goods sold during the period.
- Average inventory is a calculation that estimates the amount or value of inventory a company has over a given period of time, usually by taking the inventory levels at multiple points and finding the average.
For example, if a company’s COGS is ₹50,00,000 and its average inventory is ₹10,00,000, the inventory turnover ratio is 5. This indicates that the business sells and restocks five times a year.
- Asset turnover ratio
Where
- Net sales represent the earnings from sales less returns and discounts.
- The average total asset value of a business is determined during a certain time period by averaging its asset values.
For instance, if net sales are ₹80,00,000 and average total assets of ₹40,00,000, the asset turnover ratio is 2. This indicates the company generates ₹2 in sales for every ₹1 of assets.
- Accounts receivables turnover ratio
Accounts receivables turnover ratio = Net credit sales / Average accounts receivables
Where
- Net credit sales is the actual earnings from the sale of products or services on credit.
- Average accounts receivables are the average amount due to the business.
For example, with net credit sales of ₹60,00,000 and average accounts receivables of ₹15,00,000, the turnover ratio is 4. This suggests the company collects its receivables four times a year.
- Accounts payables turnover ratio
Accounts payables turnover ratio = Net credit purchases / Average accounts payables
Where
- Net credit purchases are the total sum of purchases done on credit.
- Average accounts payables are the average amount that the business typically owes its suppliers
If net credit purchases are ₹70,00,000 and average accounts payables are ₹35,00,000, the ratio is 2. It indicates the company pays its suppliers, on average, twice a year or every six months.
- Day’s sales in inventory
Day’s sales in inventory = 365 days / Inventory turnover ratio
Using the inventory turnover ratio of 5 from the first example, the DSI in inventory is 73 days (365/5). This means it takes, on average, 73 days to sell the entire inventory.
Bottomline
The importance of efficiency ratios cannot be overstated for investors looking to evaluate a company’s capability to leverage its resources for revenue generation. They shed light on the operational prowess and asset, inventory, receivable, and payable management skills of a company.
These numbers give investors the ability to assess a company’s operational excellence when combined with other financial data. This evaluation helps investors determine if a particular company represents a good investment opportunity based on its operational effectiveness and resource utilisation.
FAQs
The efficiency ratio measures a company’s ability to use its assets and manage liabilities to generate income effectively. It highlights how well a company manages its operations and resources, including inventory, assets, and receivables. Key examples include the inventory turnover ratio, asset turnover ratio, and accounts receivable turnover ratio. A lower efficiency ratio indicates higher operational efficiency, showing that the company is effectively converting its resources into revenue, which is crucial for assessing its financial health and operational effectiveness.
Four key efficiency ratios that businesses and investors commonly use to assess operational effectiveness include:
Inventory turnover ratio: Calculates how often a business sells and restocks over time.
Asset turnover ratio: It evaluates the effectiveness with which a business generates sales from its assets.
Accounts receivable turnover ratio: Evaluates how quickly a company collects payments from its customers.
Accounts payable turnover ratio: Determines how rapidly a company pays its suppliers.
Efficiency ratios are helpful because they shed light on how well a business uses its resources to produce revenue and profit. These ratios assist in identifying operational strengths and weaknesses by evaluating how well a business uses its inventories and assets and handles its receivables and payables. This makes it possible for managers and investors to evaluate a company’s competitive position in its industry, increase profitability, streamline operations, and make well-informed decisions.
The most important efficiency ratio can vary by industry and specific company circumstances, but the asset turnover ratio is often considered highly significant across many sectors. It gauges how well a business uses its resources to produce revenue, offering information on the efficacy of managerial techniques as well as operational efficiency. A higher asset turnover ratio indicates that the company is using its assets effectively to produce revenue, which is a key indicator of operational success and financial health.
The formulas for calculating efficiency ratios vary depending on the specific ratio being measured. Here are the formulas for the four important ratios.
Inventory turnover ratio = Cost of goods sold (COGS) / Average inventory
Asset turnover ratio = Net sales / Average total assets
Accounts receivables turnover ratio = Net credit sales / Average accounts receivables
Accounts payables turnover ratio = Net credit purchases / Average accounts payables.
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