Efficiency ratio explained: Definition, components, and types
Asset or resource allocation to generate more profit is the basis of running a business.
There are various metrics, and measurable quantities and numbers, which help a business understand the particulars of production and selling. One such important matrix is the Efficiency Ratio.
What is the efficiency ratio, and how does it work? These are questions that a business must have answers to — only then are they able to make prudential decisions regarding product sales and resource allocation.
What is efficiency ratio, and what do they measure?
The evaluation of the income of the business in relation to its resource allocation abilities is measured by efficiency ratios.
This means an efficiency ratio measures the revenue generated by the business in comparison to the expenses made to produce that revenue.
It shows how a company distributes its assets and capital to make a profit and how much amount is spent to run the business.
Efficiency ratios help to analyze the internal assets and liability management of a business. There are various different types of efficiency ratios that financial analysts measure to bring out the overall productivity picture of the business.
Different efficiency ratios are used to measure different operational variables, like repayment of liabilities, equity quantity usage, turnover of receivables, machinery, inventory use, etc. From banks to small retailers, all businesses can use efficiency ratios to determine their performance and profit.
If a business has a higher efficiency ratio, this means that it operates in a managed and well-controlled manner. Plus, it also generates maximum profit.
However, suppose a business shows a lower efficiency ratio. In that case, the situation reverses from the previous one, as profitability is not at its best and might affect the business in the long term.
Key components of efficiency ratio
Return on assets (ROA)
As the name suggests, return on assets is a popular efficiency ratio that measures the amount of profit a business earns from its assets.
This is the famous efficiency ratio because it is easier to calculate and gives investors a clear picture of the company’s performance.
Return on Assets efficiency ratio formula is net income earned by the company divided by the average total assets.
A higher ROA percentage shows that the company is able to profitably divide its assets and generate a good amount of revenue. However, a lower ROA shows a lack of efficiency and management.
Profit margin
Another very useful efficiency ratio is profit margin. Calculating the profit margin is an important measure of understanding the distribution of money.
In order to calculate the profit margin, the net income is divided by the revenue generated from the sales a company does. Meaning, the profit margin is the percentage of profit earned out of the total revenue generated.
For example, if your business earned $10,000 in total revenue in the current year, and $5000 is the net income; the profit margin of your company is 50%.
Payout ratio
Payout ratio is one more popular efficiency ratio that helps in calculating the proportion of the company’s earnings that is paid out to the shareholders.
The payout ratio number in financial reporting displays a picture that helps to decide whether the company can still sustain giving out dividends or not.
To calculate the payout ratio, the annual dividend amount payments are divided by the net income of the company per share.
If a company’s earnings increase and the stakeholder's share is still the same, they might end up thinking that the company is retaining the profits.
On the other hand, if you end up giving out more dividends, it shows that the business does not retain much to reinvest in the operations.
Types of efficiency ratios
1. Inventory turnover ratio
Inventory turnover ratio calculates the percentage of average inventory value to that of the cost of goods sold in an accounting period.
In other words, the inventory turnaround ratio expresses, within a financial year, how many times a business is able to sell out its inventory in its entirety. The formula to calculate this ratio is
Inventory turnover ratio = Cost of goods sold / Average inventory value
This helps a business understand how its inventory or stock is being sold. If the ratio is low, it should be a point of concern because this can mean that either the market demand is decreasing or the sales strategies of the company are weak.
Example: A business calculates its cost of sales to be $400,000 for the previous year, and the inventory value was approximately $80,000. The company’s inventory turnover ratio would be 5.
2. Asset turnover ratio
Every business has a different framework and belongs to different industries; hence their asset types would also vary.
Manufacturers would rely on fixed assets like machinery, travel-providing businesses would depend on transport vehicles, etc. These kinds of assets help businesses in the process of generating revenue.
When we talk about the asset turnover ratio, it means we are calculating the percentage of revenue or sales generated by investing one percent of the company assets.
Asset turnover ratio = Net sales / Average total assets
When the assets turnover ratio is high, it indicates that the company is doing a good job is efficiently using the assets and creating sales out of them. Vice-versa, when the ratio is low.
Example: The net sales done by a company for a given year are $12,000,000 and its average asset value is $6,000,000. So, its asset turnover ratio would be 2.
3. Receivables turnover ratio
The receivables turnover ratio refers to net credit sales made by a business in comparison to its accounts receivables balance. Net credit sales is a term used to define the output sold to customers on a credit basis.
This means that these sales do not get counted into cashed sales. This ratio helps a business check the potency of the techniques used for revenue collection. As this ratio ultimately creates an impact on the cash flow and operations of the company.
Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
Low receivables turnover would mean that the customers aren’t paying on time, and the techniques used for revenue collection are ineffective. A higher ratio would mean that the business has a profitable balance between the receivables and payables.
Example: The products sold on credit by a company are worth $100,000, and the average accounts receivable value is $30,000, which makes the receivable turnover ratio to be 3.3.
4. Accounts payable turnover ratio
The accounts payable turnover ratio is the opposite of the accounts receivable turnover ratio, but not exactly.
The sum of money that a company has to pay to its supplier/vendors for purchasing goods and services to run the business is called accounts payable.
Hence, naturally, the accounts payable turnover ratio would measure the percentage of net credit purchases against the average balance of accounts receivable.
Accounts payable turnover ratio = Net credit purchases / Average accounts payable
The accounts payable turnover ratio is not the exact opposite of the receivable ratio because a higher AP turnover ratio would mean that the business has an efficient invoice management system that helps them pay the vendor on time or even before the deadlines. The opposite is the case when the ratio is low.
Example: The net credit sales of a business are $300,000, and the average accounts payable is $70,000, so the accounts payable turnover ratio is 4.2.
5. Day’s sale in inventory
Day’s sale in inventory is an efficiency ratio that measures the longevity of a company’s current inventory. This means that this ratio helps in creating an estimate of how long will the current inventory or stock of the company last.
Day’s sales in inventory ratio = (Ending inventory/Cost of goods sold) x 365
It is believed that a low DSI is good as this would mean that the company has a good sales channel as the products are selling out fast.
However, if the ratio goes too low, it would indicate that there is some problem with the supply chain, and the business is not able to accurately forecast the demand of its customers.
Example: A company calculates its inventory for the last year; it is $40,000, and the cost of goods sold comes out to be $125,000. So the day's sales in inventory ratio would be (40,000/125,000) x 365 = 11.2
What is the purpose of efficiency ratios?
As we’ve seen, efficiency ratios are metrics used to measure the earnings, sales, or profit a business is making from its assets and other variables.
It is basically the evaluation of how efficiently a business is able to use its assets to generate more income. Along with this, a business’s ability to control its costs and retain profits can also be calculated.
For example, to know a company’s capital efficiency, the assets are compared to the sales done within a given period of time. All ratios come down to presenting a picture of efficient resource allocation.
To check if the efficiency ratio is low or high, you can check your company’s performance against the other business in the market within your industry.
Along with this, the efficiency ratios can be compared to the previous month’s or year’s numbers to evaluate the progress of the business over time.
Investors, business wonders, shareholders, etc., use these efficiency ratios to determine the weaknesses and strengths of the company. If an investor wants to underwrite any amount to a company, they would definitely see the company’s net profit margin.
A shareholder would be interested in a business with a higher profit margin because that company would be able to make more with its product, and this way, the investors would also make more.
An organization’s liquidity, profitability, asset allocation, and utilization all are measured through efficiency ratios.
However, every business industry has different ways of calculating efficiency ratios, as the accounting of each industry is also done through different formulas and variables. Machinery can be an asset for one industry, and assets purchased for resale are assets.
Plus, the method and variable used for efficiency calculation are also different. Hence efficiency ratios cannot be compared between industries, but they can be compared amongst businesses of the same industry.
All kinds of measures, metrics, and ratios are calculated to evaluate the performance of a business. Efficiency ratios help a company realize its financial position and make decisions according to it.
The different types of ratios mentioned above are calculated through different formulas and variables. However, those basically cover all kinds of elements that are important for the business's development.
From profit margin to inventory sales days, everything can be measured and used to make a profit.