Efficiency ratios
/What are Efficiency Ratios?
Efficiency ratios measure the ability of a business to use its assets and liabilities to generate sales. A highly efficient organization has minimized its net investment in assets, and so requires less debt and equity in order to remain in operation. In the case of assets, efficiency ratios compare an aggregated set of assets to sales or the cost of goods sold. In the case of liabilities, the main efficiency ratio compares payables to total purchases from suppliers. To judge performance, these ratios are typically compared to the results of other companies in the same industry. The following are considered to be efficiency ratios:
Accounts Receivable Turnover
Accounts receivable turnover is calculated as credit sales divided by average accounts receivable. The formula is as follows:
Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)
A high turnover rate can be achieved by being selective about only dealing with high-grade customers, as well as by limiting the amount of credit granted and engaging in aggressive collection activities. Conversely, a company might elect to have low receivables turnover as a result of a strategy to sell to lower-quality customers to which competitors refuse to sell.
Inventory Turnover
Inventory turnover is calculated as the cost of goods sold divided by average inventory. The formula is as follows:
Annual cost of goods sold ÷ Ending inventory = Inventory turnover
A high turnover rate can be achieved by minimizing inventory levels, using a just-in-time production system, and using common parts for all products manufactured, among other methods. However, it is possible to shrink inventory levels too much, if doing so results in longer delivery times to customers. It is also necessary to maintain work-in-process in front of bottleneck operations, to ensure that they never run out of work.
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Fixed Asset Turnover
The formula for the fixed asset turnover ratio is to subtract accumulated depreciation from gross fixed assets, and divide that amount into net annual sales. It may be necessary to obtain an average fixed asset figure, if the amount varies significantly over time. Do not include intangible assets in the denominator, since it can skew the results.. The formula is:
Net annual sales ÷ (Gross fixed assets - Accumulated depreciation) = Fixed asset turnover ratio
A high turnover ratio can be achieved by outsourcing the more asset-intensive production to suppliers, maintaining high equipment utilization levels, and avoiding investments in excessively expensive equipment. This turnover level varies substantially, depending on the nature of the business and the level of investment it requires.
Accounts Payable Turnover
Accounts payable turnover is calculated as total purchases from suppliers divided by average payables. The formula is:
Total supplier purchases ÷ ((Beginning accounts payable + Ending accounts payable) / 2)
Changes to this ratio are limited by the underlying payment terms agreed to with suppliers. Thus, if a supplier demands short payment terms and that is the only available supplier for a key part, then there is little management can do to improve on this ratio.
Understanding Efficiency Ratios
Efficiency ratios are used to judge the management of a business. If an asset-related ratio is high, this implies that the management team is effective in using the minimum amount of assets in relation to a given amount of sales. Conversely, a low liability-related ratio implies management effectiveness, since payables are being stretched.
Problems with Efficiency Ratios
The use of efficiency ratios can have negative effects on a business. For example, a low rate of liability turnover could be related to deliberate payment delays past terms, which could result in a company being denied further credit by its suppliers. Also, the desire to achieve a high asset ratio could drive management to cut back on necessary investments in fixed assets, or to stock finished goods in such low volumes that deliveries to customers are delayed. Thus, undue attention to efficiency ratios may not be in the long-term interests of a business.