Efficiency Ratio: Type, Formula, Interpretation

By | Januari 5, 2022

What it is: The efficiency ratio (efficiency ratio) is a financial ratio to indicate to us how well companies use their own resources, linked 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 such as short-term investments and inventories and long-term such as 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 income 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 Rasio
  • 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 are not presented in both sections.

Now, let’s discuss them one by one.

Inventory Turnover Ratio

Inventory turnover ratio (inventory turnover) measures the company’s ability to convert inventory into sales in a single 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 = Cost of goods sold / Average inventory

A higher ratio is preferred because it indicates relatively effective inventory management. Companies are relatively quick to convert their 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. Companies are relatively slow to sell their inventory, resulting in buildup, increasing inventory-related costs and weighing on 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. 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, companies may lose opportunities due to insufficient supply. 

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

As we can see from the above formula, DOH is inversely related to the inventory turnover ratio. Thus, a smaller DOH is more desirable, indicating the firm has a higher inventory turnover. Companies are quicker to convert inventory into sales and take 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 the payment from the customer when the financial statements are made. The company has to charge 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 the result of overly generous credit and collection policies, problems in billing management or the customer experiencing financial problems.

How effectively the company manages accounts receivable we can measure it with the accounts receivable turnover ratio. To calculate it, we divide the revenue accounts on the income statement and 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. The company may have effective credit collection procedures and policies. Thus, the company is faster in collecting cash payments from customers.

Meanwhile, a lower ratio indicates less effective accounts receivable management. The company struggles or takes longer to raise money. Several reasons explain that. Companies may be too lax in providing credit; Thus, customers prefer to pay at the end of the due date. 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’s the result of credit terms or strict 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 the average number of days a 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 the receivables turnover is higher, the 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 average company takes 30 days to collect money from customers. Thus, a lower DSO is preferred.

On the other hand, a higher DSO is less desirable because more money is tied to the customer. Companies need more days to collect money from customers.

Accounts Payable Turnover Ratio

Accounts payable turnover measures how quickly a 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 at the time the financial statements are issued. So, the company has an obligation to 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 represent 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. Thus, in general, a lower ratio is preferred.

A lower ratio indicates the company is paying suppliers longer. The company can use its cash for other purposes before giving it to suppliers.

  • If there is sufficient cash 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, companies are able to 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 income.

  • 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 the company 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. Companies take 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 that it takes the company on average 60 days to pay its suppliers.

Working capital turnover

Turnover of working capital (working capital turnover)  measure how efficiently the company in day-to-day operations. Working capital is the difference between current assets and current liabilities. Both accounts are on the balance sheet. Meanwhile, to calculate the ratio, we compare the income in the income statement with the average working capital in the last two years. Here is the working capital turnover formula:

  • Working capital turnover = Income / Average working capital

A higher ratio is more desirable, indicating more efficient working capital management. The company is able to use 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 income 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 accounts ( property, plant, and equipment or PP&E) . 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 income. Meanwhile, a low ratio may indicate operating inefficiency.

This ratio will vary between companies, whether they operate in labor-intensive or capital-intensive industries . In general, the ratio will be lower in companies on capital 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 will also be low.

Total asset turnover

The ratio of turnover of assets (asset turnover) illustrates the overall efficiency. It measures 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 = Earnings / Average total assets

A higher ratio indicates better efficiency. On the other hand, 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. 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.

 

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