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 |
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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 |
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