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Efficiency Ratios

Business Finance

Efficiency Ratios

Written by Gregory Steffens for Gaebler Ventures

Ratio analysis is a fundamental tool for management, investors, or other stakeholders to evaluate the health of a firm's operations. This article introduces some common efficiency ratios and how they are calculated.

No financial analysis of a company is complete without a thorough review of the company's efficiency ratios.

Efficiency ratios, such as inventory turnover, total asset turnover, and accounts receivable turnover, offer different measures of a firm's effectiveness in various areas of its operations.

Inventory Turnover

Inventory turnover ratios demonstrate a firm's ability to sell and replace their inventory over a certain period of time. High inventory turnover ratios are indicative of strong sales since companies are able to rapidly move their merchandise.

Low ratios demonstrate slow sales and an excessive inventory. Due to the vast differences in regards to inventory levels across various industries, inventory turnover ratios should only be compared to a company's historical numbers and competitors in the same industry.

The calculation of inventory turnover requires one to divide a company's net sales by its total inventory. An alternative calculation involves dividing the firm's cost of goods sold by its total inventory. While a firm's net sales can be found on the income statement, total inventory is included on the balance sheet. If a company's annual inventory turnover ratio equals four and a half, then the firm is able to rotate its entire inventory into sales four and half times each year.

Total Asset Turnover

The total asset turnover ratio shows the firm's effectiveness to generate sales from using its assets. Companies and investors alike want as high a ratio as possible since there are no negative implications from utilizing too much of a firm's assets to generate revenue.

However, asset turnover can indicate a company's pricing strategy. For example, organizations with low profit margins should have higher asset turnover, while those with higher profit margins will typically have lower asset turnover. To effectively evaluate the meaning behind this ratio, stakeholders should compare the historical numbers over time to discover any negative or positive changes in the firm's operations.

Moreover, comparing a firm's asset turnover ratio to those of its competitors allows parties to assess its operational efficiency.

To calculate asset turnover, one divides a firm's revenues by its total assets. Total revenue is located on a firm's income statement, and total assets can be found on its balance sheet. If a company has an asset turnover ratio equal to two and a half, the company earns two and a half dollars per dollar of assets invested.

Accounts Receivable Turnover

The accounts receivable turnover ratio measures the effectiveness of a firm's credit policies and its ability to collect its debts. A low accounts receivable turnover ratio indicates that the company either is not stringent enough with its credit policies or having difficulties collecting from its customers; therefore, the higher the ratio, the better.

However, a high ratio may indicate that the company deals mostly in cash with very little credit extensions or is efficient with its collections. Just like other ratios, accounts receivable turnover varies greatly between industries and comparisons should be limited to competitors within the same industry or sector.

To calculate accounts receivable turnover, one divides the firm's annual credit sales by its average accounts receivable for the year. While the amount of a firm's account receivables can be located on the balance sheet, its annual credit sales can be found on the income statement within the financial statements of its annual report.

The result demonstrates the number of times each year the company collects on all of its receivables from customers. To calculate the average collection period for the company, divide three hundred and sixty by the asset turnover ratio. For example, if the ratio equals twelve, the average collection period for the company is thirty days.

Gregory Steffens is a talented writer with a strong interest in business strategy and strategic management. He is currently completing his MBA degree, with an emphasis in finance, at the University of Missouri.