A company uses its assets to generate revenue. However, what are efficiency ratios? It is a set of ratios indicating how well a business utilizes its assets and operating expenses to generate sales. Allocation of resources is an essential function for any organisation. Business owners and managers should know the resources and how they should be utilized in the company. A company that has limited resources such as labour, raw materials etc. must plan strategically to allocate resources. In this blog, let’s learn more about efficiency ratios in detail.
What are Efficiency Ratios?
Efficiency ratios are financial ratios a company employs to measure its assets to know if it is meeting the business’s operational performance. The efficiency ratio measures a company’s efficiency in managing its assets to cover its liabilities. Hence, if the efficiency ratio is higher, it means that the business has the capability of making use of its assets effectively to cover the liabilities. In contrast, if the ratio is low, it denotes that the company has liquidity issues as they are unable to cover the liabilities with current assets.
To compute the Efficiency ratio, one divides current liabilities and current assets by the total assets. In simpler terms, efficiency ratios mean a company’s performance is based on the efficiency of the resource allocation to cover the liabilities and generate revenue. An important point to note is that the ratio is computed by dividing operating expenses by sales of that particular period. The expenses including administrative, selling and other costs occurring due to business functions come under operating expenses.
Take for instance, the asset turnover ratio assesses a company’s efficiency by examining how much sales revenue it generates for each dollar invested in net assets (total assets minus cash). The inventory turnover ratio evaluates how swiftly a company sells its inventory in comparison to the amount in stock. Meanwhile, the fixed asset turnover ratio gauges how speedily a company generates sales revenue relative to the expenditure on its fixed assets. Plus, ERP software will help provide accurate efficiency ratios for the company.
How do you calculate Efficiency Ratios?
Now we know that the efficiency ratio is a financial term used to calculate the percentage of total costs related to overhead expenses. The major use of the efficiency ratio is that it is used to calculate economic performance, especially for the ones in service companies and investors make use of it to compare the businesses functioning in the same industry.
The formula for the efficiency ratio is given below.
Efficiency Ratio = (Operating Expenses/ Net Operating Income) × 100
Those involved in the business are well aware of the profit margin. Profit margins refer to the percentage that measures how much money a company brings in from every rupee it makes.
Most businesses typically operate within a margin range of 2-5%. An efficiency ratio, which contrasts expenses with sales, swiftly indicates if you’re generating sufficient revenue to cover your operational expenses.
If your company generated ₹1 million in sales and incurred expenses of ₹800,000, your efficiency ratio would be 1.25 (₹1 million divided by ₹800,000). So, if the ratio is lower than 1, it indicates that you are at a loss. This situation can arise due to elevated overhead expenses or if your product was initially priced inadequately. If the ratio is higher, it means that the profit is greater. It also indicates that your business is providing outstanding customer service or that you are taking risk by lending out more money.
What is the purpose of Efficiency Ratios?
The intention of efficiency ratios for a firm is to manage its assets seamlessly. Take for instance, to determine if the company has enough capital to work effectively, the assets are compared to sales. In addition, this ratio is crucial as it will clearly indicate the efficiency of the company effectively by utilizing its assets and resources.
Further, this ratio is used to examine how well a company can use its assets to generate sales and gain revenue using the assets. Assets can be controlled efficaciously. The most important part is that this ratio is beneficial when comparing one business to another. However, experts suggest that the most effective way to use the efficiency ratio is to compare your company’s performance by checking previous months ratios to the current ratio.
The investors, lenders etc. require efficiency ratios to determine if it is right to invest in a particular company.
Also Read : What is Inventory? Definition, types and benefits
Examples of Efficiency Ratios
We are clear with the concept of efficiency ratios. Now, we will learn about it in depth with illustrations. We can take the example of power companies. They use the following formula to calculate efficiency ratios :
Price per Kilowatt Hour sold / cost of goods sold = efficiency ratio
This formula will accurately give them an idea regarding the profits they make with every unit of electricity sold. This analysis will help in managing costs effectively and also ensure high revenue. An efficiency ratio is determined by dividing one value by another. In the context of a power company, this ratio is derived by dividing the price per kilowatt-hour at which electricity is sold by the cost of goods sold, typically represented by the expense of procuring energy. The formula for this is given as:
Purchased Energy / Sales = Efficiency Ratio
This formula can be applied for business and to calculate personal finance as well.
Types of Efficiency Ratios
Enumerated below are some of the popular types of efficiency ratios.
1. Inventory turnover ratio
The inventory turnover ratio signifies how many times a business depletes its inventory of goods within a specified time frame. To compute the ratio, you divide the cost of goods sold by the average inventory maintained during a specific time frame such as for one year.
Inventory turnover ratio = Cost of Goods sold/ Average inventory
2. Accounts receivable turnover ratio
The formula for the accounts receivable turnover ratio is given below.
Accounts receivable turnover ratio = Net credit sales/ Average accounts receivable
Here, Net credit sales refers to sales in which the proceeds are collected at another time.
Net credit sales = Sales on credit – Sales returns – Sales allowances
The Average Accounts Receivable is determined by adding the initial and final balances of accounts receivable for a given period (such as monthly or quarterly) and then dividing the total by 2.
Accounts receivable ratio, an important concept measures the effectiveness of revenue collection. The accounts receivable turnover ratio examines the frequency in which the company collects the average accounts receivable over a period.
3. Accounts payable turnover ratio
The formula to measure this concept is given below.
Accounts payable turnover ratio = Net credit purchases/ Average accounts payable
In this, net credit purchases = Cost of Goods sold(COGS) + Ending inventory balance – Starting inventory balance for a specific period.
This formula is applicable for general purposes only. Plus, the purchases can be made only on credit. Alternatively, due to the challenge of obtaining the figure for net credit purchases, analysts frequently use Cost of Goods Sold (COGS) as a substitute in the numerator.
Average accounts payable – The Average accounts payable is calculated by adding the initial and final balances of accounts payable for a specified period (such as monthly or quarterly) and then dividing the total by 2. The balances(of both) are documented in the company’s balance sheet.
The Accounts payable turnover ratio refers to the average regularity in which the creditors are paid at the end of an accounting period. In addition, the accounts payable turnover ratio is also used to measure short-term liquidity. A higher turnover ratio is a boon for the company as it gets to hold cash for a longer period of time. As a result, this reduces the gap in funding for working capital or shortens the working capital cycle.
4. Asset turnover ratio
The formula for the asset turnover ratio is given below.
Asset turnover ratio = Net sales/ Average total assets
Here net sales is all the sales minus sales returns, sales discounts and sales allowances.
Average Total Assets = (Total assets at the end of the period + Total assets at the beginning of the period) / 2.
5. Fixed Asset Turnover Ratio
The fixed asset turnover ratio is quite similar to the asset turnover ratio. In the case of these efficiency ratios, only the long-term fixed assets are considered. Here, the efficiency ratios are measured by analysing the fixed assets such as manufacturing plants, machinery and equipment.
Fixed asset turnover ratio = Net sales/ Average fixed assets
When considering the total asset ratio, a higher ratio is good as it indicates that the company has used the fixed assets usefully.
6. Total Asset Turnover Ratio
This is a profitability ratio that examines and calculates how many rupees in sales can be generated from each rupee in assets. Assets will differ depending on the business type. For example, property managers turn to fixed assets such as real estate. Publishers may lean towards using intellectual property assets as a primary source of revenue generation. If this type of efficiency ratio is high, it indicates a company’s ability to produce sales from assets. On the contrary, if the asset turnover value is low, then the company’s inability is revealed.
Asset turnover ratio = Net Sales/ Average total assets
What are the key components of Efficiency Ratios?
Efficiency ratios play a pivotal role in the financial sector, serving as key metrics that financial analysts typically rely on to assess the overall performance of an organization’s operations. Some of the common efficiency ratios are enumerated below.
1. Return on Assets (ROA) – By dividing net income and total assets, ROA measures how much profit an organisation generates.
2. Profit Margin – A firm’s operating performance is measured. Plus, the profit margin divides operating income by total sales.
3. Payout Ratio – It examines the dividends a company is paying its shareholders when compared to the earnings.
Conclusion
Efficiency ratios are used to measure how well a company utilizes its assets to generate revenue. Some common types of efficiency ratios are Accounts payable turnover ratio, inventory turnover ratio, accounts receivable turnover ratio, fixed asset turnover ratio etc.
Automation is the best option to measure a company’s efficient ratios accurately. An accounts receivable software and accounts payable automation system will help in effectively managing a company’s assets to generate higher profit margins.
