What’s it: An efficiency ratio is a financial ratio to show us how well a company utilizes its assets in relation to its ability to generate revenue. Some examples include accounts payable turnover ratio, inventory turnover ratio, and accounts payable turnover ratio. Some give us insight into how effectively a company manages its short-term assets or working capital. Meanwhile, others are useful for assessing long-term asset utilization.
Why is the efficiency ratio important?
Assets represent the economic resources belonging to the company. They can be short-term, like marketable securities and inventories, and long-term, like property, plant, and equipment (PP&E). The company utilizes them to run its operations and generate revenue.
How well is the company using its assets to generate revenue?
We measure it by the efficiency ratio. It is an important metric to measure a company’s performance, in addition to profitability, liquidity, and solvency ratios. It gives us insight into how efficient and effective a company is in managing its assets and carrying out day-to-day operations, such as collecting accounts receivable, managing inventory, and managing accounts payable. In addition, it also measures how well the company manages its obligations related to working capital.
What are the types of efficiency ratios? And, what are their formulas and interpretations?
We can use several efficiency ratios to measure the company’s asset management related to its ability to generate revenue and fulfill obligations in working capital. They include:
- Inventory turnover ratio
- Days of inventory on hand (DOH)
- Accounts receivable turnover ratio
- Days sales outstanding (DSO)
- Accounts payable turnover ratio
- Days payable outstanding (DPO)
- Working capital turnover ratio
- Fixed asset turnover ratio
- Total asset turnover ratio
Their calculations are relatively easy because they only require simple arithmetic operations. We compare the accounts on the income statement with the accounts on the balance sheet. In specific cases, such as working capital and purchases, we need manual calculations because the data we need is not presented in both sections.
Now, let’s discuss them one by one.
Inventory turnover ratio
The inventory turnover ratio gauges a company’s ability to convert inventory into sales within an accounting period, usually one year. The calculation requires us to divide the cost of goods sold by the average inventory. You can find both accounts on the income statement and balance sheet.
We use the average inventory for the last two years to avoid misinterpretation due to significant changes due to sharp fluctuations in the numbers. To calculate it, add up this year’s inventory figure with the previous year’s inventory. Then, divide the result by 2.
The mathematical formula for the inventory turnover ratio is as follows:
- Inventory turnover ratio = Cost of goods sold / Average inventory
A higher ratio is preferable because it indicates relatively effective inventory management. Companies are relatively fast in converting inventory into sales. So, it can reduce the cost related to inventory. In addition, the company also quickly sells products to customers.
Conversely, lower ratios generally indicate less effective inventory management. For example, the company is relatively slow to sell its inventory, resulting in the buildup, increasing inventory-related costs, and weighing company profits. Or, it indicates the company may be having problems selling products to customers.
However, we must also be careful to draw conclusions. For example, a high ratio can also result from insufficient inventory. This is because more items are sold than added to the warehouse. In other words, sales increase faster than inventory increases. Thus, while future demand will remain strong, the company may lose opportunities due to insufficient supplies.
Days of inventory on hand
We can use the inventory turnover ratio above to calculate another ratio, namely, days of inventory on hand (DOH). If the inventory turnover ratio measures the number of times a company converts its inventory into sales in a year, then the DOH tells, on average, how many days it took. To get the DOH, we divide the number of days in a year (365 days) by the inventory turnover. Here is the formula:
- DOH = 365 / Inventory turnover ratio
From the above formula, we can see, DOH is inversely related to the inventory turnover ratio. Thus, a smaller DOH is more desirable, indicating the company has a higher inventory turnover. It converts inventory into sales faster and takes fewer days to do so.
Conversely, a higher DOH indicates the company needs more days to sell inventory. Thus, more money is tied up in inventory.
Accounts receivable turnover ratio
The accounts receivable turnover ratio measures the company’s effectiveness in managing accounts receivable. Accounts receivable arise because the company sells products on credit. Thus, the company has delivered the product but has not yet received payment from the customer when the financial statements are made. As a result, the company has to collect it.
More accounts receivable, more money tied up with customers. And, it is a problem if the customer is late paying or failing to pay. It could be due to overly generous credit and collection policies, problems in billing management, or the customer is having financial problems.
How effectively the company manages accounts receivable, we can measure it with the accounts receivable turnover ratio. To calculate it, we divide revenue in the income statement and the accounts receivable in current assets. The following is the accounts receivable turnover formula:
- Accounts receivable turnover = Revenue / Average accounts receivable
A higher ratio is preferred because it indicates better accounts receivable management. For example, the company may have effective credit collection procedures and policies. Thus, it is faster in collecting cash payments from customers.
Meanwhile, a lower ratio indicates less effective accounts receivable management. As a result, the company struggles or takes longer to raise money. Several reasons explain that. The company may be too lax in providing credit. Thus, customers prefer to pay at the end of the due date of receivables. Or, it may be due to the company’s ineffective credit collection processes and procedures.
However, we must also be careful in translating this ratio. For example, a high ratio may raise other suspicions. If it results from strict credit terms or billing policies, it could create problems later on. It can worsen long-term relationships with customers. If, at the same time, they find an alternative company with more lax requirements, they may turn to it.
Days of sales outstanding
Days of sales outstanding (DSO) is a derived ratio of accounts receivable turnover. It shows how many days on average the company collects payments from customers in a year. To get it, we divide the number of days in a year (365 days) by the accounts receivable turnover. The formula for days of sales outstanding is as follows:
- DSO = 365 / Accounts receivable turnover
DSO is inversely proportional to accounts receivable turnover. So, when receivables turnover is higher, DSO will be lower. That means companies are quicker to collect payments and take fewer days to do so. For example, DSO 30 means that the company takes, on average, 30 days to collect money from customers. Thus, a lower DSO is preferred.
On the other hand, higher DSOs are less desirable because more money is tied to the customer. The company needs more days to collect money from customers.
Accounts payable turnover ratio
Accounts payable turnover measures how quickly the company pays its accounts payable. It is an account in current liabilities and arises when a company purchases goods on credit from a supplier. The company has received the goods but has not paid for them when the financial statements are prepared. Thus, the company must pay for it. Long story short, accounts payable are the opposite of accounts receivable.
- Accounts payable turnover = Purchases / Average accounts payable
We calculate the accounts payable turnover ratio by dividing purchases by accounts payable. Purchase data is not presented in the financial statements. So, we have to calculate it manually using the following formula:
- Purchases = Ending inventory + Cost of goods sold – Beginning inventory
Ending inventory and beginning inventory represents inventory figures for this year and last year. Both are in current assets. Meanwhile, the cost of goods sold (COGS) is in the income statement.
Accounts payable turnover tells us how many times a company pays suppliers in a year. The sooner the company pays, the faster the cash will come out. So, in general, a lower ratio is preferable.
A lower ratio indicates the company is paying suppliers longer. This is because the company can use its cash for other purposes before giving it to suppliers.
- If sufficient cash is available, a low ratio should not be an early signal of a liquidity crisis. On the other hand, the company managed to manage its accounts payable well. For example, it can exploit lenient credit terms from suppliers.
- But, if the cash position is insufficient, it could indicate a liquidity problem. The company lacks cash, so it is difficult and takes longer to pay suppliers on time.
Conversely, a higher ratio indicates the company is quicker to pay suppliers. It is usually less preferred because there is a missed profit opportunity. For example, a company can use its money to invest in short-term liquid instruments (cash equivalents) to generate revenue.
- Several reasons explain that. First, supplier credit terms are more stringent. Second, the company cannot take full advantage of the available credit facilities and pays creditors too quickly. Third, the company wants to take advantage of facilities such as discounts offered by suppliers if it pays early. If the ratio is higher for the third reason, it shouldn’t be a problem.
Days payable outstanding
Days payable outstanding (DPO) is inversely related to trade payable turnover. If business turnover shows how many times the company pays suppliers in a year, then DSO shows how many days it is done. We calculate DSO by dividing the number of days in a year by the accounts payable turnover.
- Days payable outstanding = 365 / Accounts payable turnover
Since it is inversely related, a higher DSO is usually preferred. The company takes longer to pay suppliers. It can signal the company’s success in managing accounts payable and utilizing available credit facilities. For example, a DPO value of 60 means the company takes 60 days to pay its suppliers.
Working capital turnover
This ratio gauges how efficiently the company operates daily. Working capital points to the difference between current assets and current liabilities. Both accounts are on the balance sheet. Meanwhile, to calculate the ratio, we compare the revenue in the income statement with the average working capital in the last two years. Here is the working capital turnover formula:
- Working capital turnover = Revenue / Average working capital
A higher ratio is more desirable, indicating more efficient working capital management. The company can utilize its working capital well to make money.
Fixed asset turnover ratio
The fixed asset turnover ratio measures the company’s effectiveness in managing fixed assets to generate revenue. To calculate it, we divide revenue by the average fixed assets in the last two years. In the financial statements, you may find fixed assets presented as property, plant, and equipment (PP&E) accounts. It’s in non-current assets on the balance sheet.
- Fixed asset turnover = Revenue / Average net fixed assets
A higher ratio indicates better efficiency in utilizing fixed assets to generate revenue. Meanwhile, a low ratio may indicate operating inefficiency.
This ratio will vary between companies, whether they operate in labor-intensive or capital-intensive industries. The ratio will generally be lower in capital-intensive companies because they rely more on fixed assets such as heavy machinery and equipment.
Furthermore, how long the company has been operating also affects this ratio. For example, a new company has not been able to generate high sales. Thus, the numerator of this ratio is also low.
Total asset turnover
The asset turnover ratio describes the overall efficiency. It gauges how well a company manages its assets, both short-term and long-term, to generate revenue. To get this, we divide revenue by the average total assets of the last two years. The asset turnover formula is as follows:
- Asset turnover = Revenue / Average total assets
A higher ratio indicates better efficiency. In contrast, a lower ratio indicates that the company is less efficient.
How to use the efficiency ratio?
Ratios are useful when we compare companies in the same industry. We can have an idea and understanding of why a company is superior to its competitors.
Also, comparing the same ratio over time is another way to gain deeper insight. So, we can track how effective management’s strategies and efforts are to manage the business and make money over time.
Both approaches – comparisons with peers and over time – are important in drawing more objective conclusions and assessments.