The Efficiency Ratio Explained- Definition, Formula

What is Efficiency Ratio

The ability of a company to generate sales while making use of its assets and liabilities is what efficiency ratios try to measure. An organization that is highly efficient has minimized its net investment in assets, and as a result, it needs fewer resources, including capital and debt, to continue being in business. Efficiency ratios compare an aggregated set of assets to sales or the cost of goods sold when discussing the topic of assets. When it comes to liabilities, the most important efficiency ratio is the one that compares payables to the total amount of money spent on purchases from suppliers. It is common practice to evaluate a company's performance by comparing its ratios to the results of other businesses operating in the same sector. The following are examples of ratios that are considered to be efficient:

What Are The Four Efficiency Ratio

1) Accounts Receivable Turnover

The ratio of credit sales to average accounts receivable is what is used to determine the turnover of the accounts receivable. A high turnover rate can be achieved by being selective about the types of customers with whom one does business, only dealing with high-grade customers, and limiting the amount of credit that is extended to customers while also engaging in aggressive collection activities. On the other hand, a company may deliberately choose to have a low receivables turnover as a result of a business strategy that involves selling to customers of a lower quality, to whom other businesses will not sell.

Formula:

2) Inventory Turnover

The cost of goods sold is divided by the average inventory to arrive at the formula for calculating inventory turnover. A high turnover rate can be achieved in a variety of ways, including reducing the amount of inventory held, implementing a production method known as just-in-time, and making use of standard components across the board for all goods produced. Nevertheless, it is possible to reduce inventory levels an excessive amount if doing so results in longer delivery times to customers. In this case, the inventory levels should not be reduced. In addition, it is essential to keep work-in-process ahead of bottleneck operations so that those operations do not ever find themselves without anything to do.

Formula:

3) Fixed Asset Turnover

To calculate the turnover of fixed assets, simply divide total sales by the average value of fixed assets. Maintaining high levels of equipment utilisation and avoiding investments in excessively pricey equipment are key factors in achieving a high turnover ratio. This can be accomplished by outsourcing the production tasks that require the most asset investment to third-party suppliers. This level of turnover varies greatly depending on the kind of business being conducted and the amount of investment that is required by that kind of business.

Formula:

4) Accounts Payable Turnover

When calculating accounts payable turnover, total purchases from suppliers are divided by average payables. This gives the accounts payable turnover percentage. The underlying payment terms that have been agreed to with suppliers are what put a cap on how much this ratio can shift. Therefore, if a supplier insists on having short payment terms and that particular supplier is the only one who can provide a key part, then there is not much that management can do to improve upon this ratio.

Formula:

Limitation with Efficiency Ratio

The application of efficiency ratios may bring about unintended consequences for a company. For instance, a low rate of liability turnover could be the result of intentional payment delays that extend past the terms of the agreement, which could lead to the company's suppliers refusing to extend further credit to the business. Also, the management may be motivated to reduce necessary investments in fixed assets in order to achieve the goal of having a high asset ratio. Alternatively, the management may choose to stock finished goods in such a small quantity that it causes delays in delivering the goods to the customers. Therefore, paying an excessive amount of attention to efficiency ratios might not be in the best interests of a company over the long term.

Summary of Efficiency Ratio