Efficiency ratios : Explained

How do I measure if a company is optimally using its assets and resources to generate revenue?

In the previous article on financial ratios, we have covered the leverage ratios in detail. If you haven’t gone through that yet, you can find the link for the post here

We now look at the next set of ratios, which are the efficiency ratios

What are efficiency ratios and why are they important?

Efficiency ratios are used to measure how well the company is using its assets and resources to generate revenue. It helps us in understanding if the company is optimally utilizing its resources in generating revenue and profits as compared to its peers

Some of the commonly used efficiency ratios in the industry are:

1. Inventory turnover ratio

2. Asset turnover ratio

3. Receivables turnover ratio

We’ll again follow the same example that we have used in explaining the other financial ratios by calculating the efficiency ratios for our company Marvel, which is into the business of manufacturing and selling cars

And its financial statements read as follows:

• Inventory means all the finished goods that are in stock which are ready to be sold

• Account receivables implies the amount the company is yet to receive for the goods it has sold to its client

• Cost of goods sold means the total cost incurred by company in manufacturing the goods which were sold

Given this scenario, let’s understand the efficiency ratios for Marvel by looking at the values of the 3 ratios:

1. Inventory turnover ratio:

It tells us 2 things:

1. If enough sales are being generated so that inventory is clearing quickly

2. If the company is managing its inventory efficiently, as in, is it keeping too much of inventory or falling short of inventory in line with the rate of sales

Should it be high or low:

• If its high, it means the company’s goods are selling quickly and hence good for the company

• But if it’s very high it could also mean that you are not keeping enough inventory to match the sales, hence could miss out on sales opportunities

So, high ratio is good, but if its too high then you should keep more inventory to match sales. The same way, if the ratio is low, it means your products or not selling fast or you are having too much inventory

Now let’s calculate this ratio for Marvel:

=(Cost of goods sold) / (Inventory)

=200 / 50

=4

What does this 4 mean?

• It means that Marvel’s sales are happening at a higher rate than the inventory it has, indicating that Marvel’s goods are being sold rapidly, which is good for the company

• While its good, Marvel also has to check if it is keeping sufficient inventory to match the sales

A more useful number in this scenario is the "days inventory turnover" which is more commonly used by analysts. We’ll explain what it exactly means by calculating the number for Marvel:

Days inventory

=(1/Inventory turnover ratio)*365

=(1/4)*365

=91.25 days

What this number means is that Marvel is selling its entire inventory within 91.25 days. Now is this 91.25 days good or bad, we’ll know that only after comparing with similar companies in the industry

2. Asset turnover ratio:

It measures the company’s ability to efficiently generate revenues from its assets. The ratio tell us how much revenue is generated from each Rs. of assets the company owns

Assets here include both tangible (machinery, equipment etc) as well as intangible (goodwill, brand recognition, patents, intellectual property etc)

A high ratio means company is using its assets efficiently, while lower means the opposite

For Marvel, this ratio:

=(Total sales) / (Total assets)

=600/900

=0.67

It means the company earns 0.67 Rs for every 1 Rs of the assets. Doesn't look that good, does it? Compare with its peers and you will know

3. Receivables turnover ratio:

This ratio tells us how effective the company is in collecting its payments and extending the credit to its customers

Typically, a higher ratio relative to its peers is favorable. Lower ratio means the company is slow in collecting the payments for the goods it has sold

Let’s look at this ratio for Marvel:

=(Total sales) / (Accounts receivables)

=600/200

=3

It means that the company has collected payments 3 times for the period, which implies it is collecting payments at a healthy rate for the cars it is selling and keeping its bank filled with cash

Again, we should compare this ratio with other competitors of Marvel in the industry before making a judgement it its efficient or not

Hope you have now understood the importance of efficiency ratios and can use them in determining if a company is efficiently using its resources in generating revenues

We’ll look at the next set of ratios, which are the profitability ratios, in our next post. Until then if you have any questions, do let us know in the comments below