Efficiency Ratios

Efficiency Ratios are a measure of how well a company is managing its routine affairs. Conceptually, these ratios analyze how well a company utilizes its assets & how well it manages its liabilities.

Let’s look at each efficiency ratio closely to get a better idea:

TYPES OF EFFICIENCY RATIOS

Accounts Receivable Turnover

This ratio measures how quickly a company collects bills from its customers. It is an indicator of how efficient a company’s credit policies are & indicates the level of investment in receivables needed to maintain the firm’s sales level. The formula of accounts receivable turnover is:

Formula

Accounts Receivables Turnover = Revenue/Average Accounts Receivable

Interpretation

Higher accounts receivable turnover is better for any company. If for any company the accounts receivable turnover is too low, it indicates that a company is having difficulty in collecting from its customers or it is being too generous with granting credit.

Average No. of Days Receivables Outstanding

We can go one step further and calculate the average number of days of receivables outstanding. The formula is:

Average No. of Days Receivables Outstanding = 365/Accounts Receivables Turnover

The result will indicate on average in how many days a company is collecting its bills.

Inventory Turnover

Inventory turnover ratio measures how efficiently a company manages its inventory. The formula of inventory turnover is:

Formula

Inventory Turnover = Cost of Goods Sold/Average Inventory

Interpretation

A lower inventory turnover ratio indicates that a company is not managing its inventory well. It may be overstocking or it might have an issue with sales. A higher inventory turnover ratio is always better because it indicates that inventory does not remain on shelves but rather turns over rapidly.

Average No. of Days Inventory in Stock

We can further calculate the average number of days inventory in stock as follows:

Average No. of Days Inventory in Stock = 365/Inventory Turnover

The result will indicate on average in how many days a company’s inventory is held until it is sold.

Accounts Payables Turnover

Although accounts payable are liabilities rather than assets, their trend is important as they represent an important source of finance for operating activities, thereby affecting operating efficiency. This ratio is important because it measures how a company manages its own bills. The formula of account payables turnover is:

Formula

Accounts Payables Turnover = Total Purchases/Average Accounts Payables

Interpretation

A high accounts payable turnover ratio indicates that firm is not managing its bills very well, maybe it is not getting favorable credit terms from its suppliers. A low accounts payable turnover is better. Learn more about it here How to Manage Accounts Payable?.

Average No. of Days Payable Outstanding

We can further calculate the average number of days payable outstanding as follows:

Average No. of Days Payable Outstanding = 365/Accounts Payables Turnover

The result will indicate the average number of days in which a company pays its suppliers.

Working Capital Turnover

Working capital turnover ratio reflects the amount of operating capital needed to maintain a given level of sales. Only operating assets & liabilities should be used to compute this ratio. The formula of the working capital ratio is:

Formula

Working Capital Turnover = Sales/Average Working Capital

Note – Working Capital = Current Assets-Current Liabilities

Interpretation

A higher working capital turnover ratio is always better. A higher working capital indicates that a company is utilizing its working capital very efficiently. A low working capital ratio is an indicator that the company is not operating at its optimum.

Fixed Assets Turnover

The fixed assets turnover ratio measures the efficiency of a company’s long-term capital investments. It reflects the level of sales generated by investments in productive capacity. The formula of fixed assets turnover is:

Formula

Fixed Asset Turnover = Sales/Average Fixed Assets

Interpretation

Interpreting fixed asset turnover ratio is tricky. This is because this ratio is affected by many circumstances such as life cycle of a company, life cycle of a product, initial plant capacity & relative sales. Also, there are factors such as asset valuation (accounting of depreciation), the timing of firms asset purchase, etc. that affects this ratio. Thus all else equal, the higher the total asset turnover, the better.

Total Asset Turnover

This ratio provides a measure of overall investment efficiency by totaling the joint impact of both short-term and long-term assets. The ratio can be calculated as follows:

Formula

Total Assets Turnover = Sales/Average Total Assets

Interpretation

Like fixed asset turnover ratio, total asset turnover ratio is also affected by similar factors. All else equal, a higher asset turnover is better as it indicates how effectively entire funds (Assets=Capital + Liabilities) of a company is used. It is a holistic measure of a company’s equity.

EFFICIENCY RATIOS EXAMPLE

FINANCIAL SUMMARY OF CISCO SYSTEMS

Following is the table representing the financial summary of Cisco Systems:

PARTICULARS 2008 (IN MILLION USD) 2007 (IN MILLION USD)
Net Sales 39,540 34,922
Cost of Goods Sold 14,056 12,586
Accounts Receivable 3,821 3,989
Average Accounts Receivable (3,821+3,989)/2=3,905
Accounts Payable 869 786
Average Accounts Payable (869+786)/2=827.50
Current Liabilities (A) 13,858 13,358
Current Assets (B) 35,699 31,574
Working Capital (B)-(A) 35,699-13,858=21,841 31,574-13,358=18,216
Average Working Capital (21,841+18,216)/2=20,028.5
Inventories 1,235 1,322
Average Inventory (1,235+1,322)/2=1278.5
Fixed Assets 4,151 3,893
Average Fixed Assets (4,151+3,893)/2=4,022
Total Assets 58,734 53,340
Average Total Assets (58,734+53,340)/2=56,037

With the help of above summary, we have calculated the efficiency ratios and they are presented as below. This will give a fair idea on how to calculate efficiency ratios.

RATIO CALCULATION FOR THE YEAR 2008

EFFICIENCY RATIOS

FORMULA

CALCULATION

RATIO

Accounts Receivables Turnover Sales/Average Accounts Receivables 39,540/3,905 10.13
Average No. of Days Receivables Outstanding 365/Accounts Receivables Turnover 365/10.13 36.03 Days
Inventory Turnover Cost of Goods Sold/Average Inventory 14,056/1278.5 11
Average No. of Days Inventory in Stock 365/Inventory Turnover Ratio 365/11 33.18 Days
Accounts Payables Turnover Total Purchases/Average Accounts Payables 13,969/827.50 16.88
Average No. of Days Payable Outstanding 365/Accounts Payables Turnover 365/16.88 21.62 Days
Working Capital Turnover Sales/Average Working Capital 39,540/20,028.5 1.97
Fixed Asset Turnover Sales/Average Fixed Assets 39,540/4,022 9.83
Total Assets Turnover Sales/Average Total Assets 39,540/56,037 0.71

Reference:

Books-

The Analysis & Use of Financial Statements, 3rd Edition – Gerald I. White, Ashwinpaul C. Sondhi, Dov Fried

Last updated on : May 7th, 2018

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