Most businesses exist for the purpose of generating profit and satisfying the consumers’ needs. It is the role of the management to ensure such objectives are attained, and hence must gather sufficient data to inform them how the business is doing. As a manager, you must ask yourself questions such as whether the company’s market share has improved, or whether the assets are generating enough revenue relative to the amount of money invested, the last of which can be calculated using efficiency ratios.
To do this, most managers rely on ratio analysis to help them understand trends and financial statements, which provide crucial information about the company’s performance. Ratio analysis helps them detect strengths and weaknesses of various initiatives and strategies.
The tools can also be used to analyze the company’s performance against other firms in the industry, as well as pinpoint any actions that require corrective measures before it is too late. For example, a quick acid ratio, which measures whether the company has sufficient liquid assets to meet its immediate liabilities, can provide a warning before its debts spiral out of control.
Classification of Financial Ratios
Ratios can be grouped into profitability ratios, liquidity ratios, leverage (gearing) ratios and efficiency ratios, with the former being the focus of this article. Before we explore efficiency ratios, let’s have a look at the qualities of useful financial ratios. You can learn more about the efficiency ratios in this course, which may further expand your knowledge of them. The qualities of ratios are;
- They must be calculated regularly from time to time
- The must be based on accurate and reliable financial information
- They must be viewed both as an indicator of wide issues and trends in the long-run and also at a particular point in time.
- They must be used internally for performance evaluation
- They must also be used to compare the company’s performance relative to its industry peers.
- Must not be relied upon solely for making decisions, as there are other factors at play
Types of Efficiency Ratios
1. Accounts Receivable Turnover
The accounts receivable turnover is used to measure the efficiency of your company’s credit policies. Too low accounts receivable turnover may show that your company is either finding it hard to collect debts from customers or that it is granting credit too easily. All factors being equal, a high accounts turnover is recommended.
Accounts Receivable Turnover = Revenue / (Average Accounts Receivable)
2. Inventory Turnover
Inventory turnover can help you determine how well you are managing your company’s inventory levels. If the figure is too low, it means that you are overbuilding or overstocking the inventory, or that you are having problems pushing sales to consumers. Hence, the higher the inventory turnover, the better your inventory management policy is. It is measured as follows;
Inventory Turnover = (Cost of Sales) / (Average Inventory)
3. Accounts Payable Turnover
This ratio measures whether the company has sufficient resources to pay its immediate bills. If the figure is high, it shows that the company isn’t getting healthy payment terms from the suppliers. It is measured as follows
Accounts Payable Turnover = (Cost of Sales) / (Average Accounts Payable)
4. Total Assets Turnover
The total asset turnover shows how efficiently you are using both long-term and short-term assets. In other words, it measures how efficiently each dollar of your company’s assets is generating sales. An ideal figure is a high total asset turnover. A total assets turnover ratio of 4 means that for each dollar of total assets, the business earns 4 dollars in revenue. It is computed as shown;
Total Asset Turnover = (Revenue) / (Average Total Assets)
5. Fixed Asset Turnover
This ratio is similar to the total asset turnover, though there are some differences. Fixed assets, also referred to as property, plant & equipment or non-current assets, refers to assets that cannot be converted to cash quickly. The higher the figure, the better as it indicates the amount of money held in the fixed assets is lower per dollar of sales revenue. If the ratio is low, it indicates that the company has invested too much on fixed assets. It is computed as follows;
Fixed Asset Turnover= Net Sales/ (Average Net Fixed Assets), or
Fixed Asset Turnover= (Revenue)/ (Average Fixed Assets)
6. Operating Expense Ratio
This ratio measures the cost of operating a property against the income it brings. It helps compare expenses between analogous properties. If a property has a high operating expense ratio, it is a signal that corrective measures must be taken to rein the costs. Expenses that can be used in computing this ratio vary, with the common ones being insurance, taxes, maintenance and utilities against the gross income. A sum of expenses can also be computed against the total income, something you will learn how to interpret by studying for this course on ratios. It is calculated as follows;
Operating Expense Ratio= (Operating Expenses)/ (Total Gross Income or revenue)
7. Return on Investment
The return on net profit calculates the efficiency with which the net worth generates net profit. It computes the number of dollars in net profit generated for each dollar invested in net worth. Therefore, a return on investment ratio of 17% can be interpreted as for each dollar invested in net worth, the business is producing 17 cents in net profit before tax. This ratio is computed as shown below;
Return on Investment= (Net Profit before Tax)/ (Net Worth)
8. Average Collection Period
Also known as the days’ sales in accounts receivable, this ratio refers to the average number of days between when a credit transaction is processed to the date the customer pays for the product obtained. It helps the company manage its cash flows so that it can meet its current obligations as they fall due. So an average collection period of 20 days means the business must wait for 30 days before the debtor can pay up. It is derived as follows;
Average Collection Period= (365 days in a year)/ (Accounts Receivable Turnover)
9. Average Payment Period
This ratio calculates the average number of days the business takes to pay its trade debts. Therefore, an accounts turnover ratio of 25 means the company on averages settles its accounts payable within 25 days. This ratio is computed as shown below;
Average Payment Period= (365 days in a year) / (Accounts Payable Turnover)
Limitations of Efficiency Ratios
While efficiency ratios can be a useful indicator of a company’s performance over time, they have their own drawbacks such as;
- Effects of Inflation- inflation may result in distortion of data, especially with regard to the firm’s balance sheet. This also affects profits and the company’s bottom-line. Hence such ratios should be carefully used when internally comparing the company’s performance over time, or when comparing it against a peer of different age.
- Seasonal Influences- Sometimes, a company may accumulate stocks and buy equipment in preparation for a “high-season” when sales are higher. As such, the efficiency ratios may be lower, though this is not the case.
- Different Accounting Practices-Different firms use varying accounting practices, meaning you should exercise discretion when using the efficiency ratios.
- Most giant companies, or conglomerates, operate in different business sectors. This means it is hard to obtain solid data for cross-comparison.
Efficiency ratios can help you determine whether your business is squeezing every dollar it can from its operations. It also helps you manage it efficiently, though; it is advised that you should be aware that there are other factors at play that influence the performance of your business.