This article will be a guide to the efficiency ratio formula. In this article we discuss formulas for calculating efficiency ratios along with practical examples.
Understanding What Efficiency Ratio Is
Efficiency Ratio or efficiency ratio is a measure of how well the company manages its routine affairs.
Conceptually, this ratio analyzes how well the company uses its assets & how well it manages its liabilities.
So the efficiency ratio is a measure of how effectively a company manages its assets and liabilities and includes formulas such as asset turnover, inventory turnover, accounts receivable turnover, and payable turnover.
Let’s take a closer look at each efficiency ratio to get a better idea:
Type of Efficiency Ratio
1. Accounts Receivable Turnover
This ratio measures how quickly a company collects invoices from its customers.
This ratio is an indicator of how efficient a company’s credit policy is & shows the level of investment in receivables needed to maintain the company’s sales level. Accounts receivable turnover formula is:
Accounts Receivable Turnover = Revenue/Average Accounts Receivable
Higher accounts receivable turnover is better for any company. If for any company accounts receivable turnover is too low.
This ratio indicates that the company has difficulty in collecting from its customers or is too generous with lending.
Average Number of Days Receivable Extraordinary
We can go one step further and calculate the average number of days receivable outstanding. The formula is:
Average Days Receivable Payable = 365/Receivable Turnover
The results will show the average number of days a company collects its invoices.
Read also Understanding Debits and Credits in Accounting .
2. Inventory Turnover
The inventory turnover ratio measures how efficiently a company manages its inventory. The inventory turnover formula is:
Inventory Turnover = Cost of Goods Sold /Average Inventory
A lower inventory turnover ratio indicates that the company is not managing its inventory properly.
Maybe it’s overstocked or maybe there’s a problem with sales.
A higher inventory turnover ratio is always better because it indicates that inventory does not stay on the shelves but is changing rapidly.
Average Number of Days Inventory in Stock
Then we can calculate the average number of days of inventory in stock as follows:
Average Number of Days Inventory in Stock = 365/Inventory Turnover
The results will show the average number of days the company’s inventory is held until it is sold.
3. Accounts Payable Turnover
Although accounts payable are liabilities rather than assets, the trend is important because they are an important source of finance for operating activities, thereby affecting operating efficiency.
This ratio is important because it measures how the company manages its own bills. Accounts payable turnover formula is:
Accounts Payable Turnover = Total Purchases/Average Accounts Payable
A high debt turnover ratio indicates that the company does not manage its bills well, may not get favorable credit terms from its suppliers.
Lower debt turnover is better. Learn more here How to Manage Debt? .
Average Number of Days Outstanding Debt
We can then calculate the average number of days payable as follows:
Average Number of Days Payable Extraordinary = 365/Accounts Payable Turnover
The result will show the average number of days the company pays its suppliers.
Read also Understanding What is Short-Term Debt? .
Working Capital Turnover
The working capital turnover ratio reflects the amount of operating capital required to maintain a certain level of sales.
Only operating assets & liabilities should be used to calculate this ratio. The working capital ratio formula is:
Working Capital Turnover = Sales/Average Working Capital
Note – Working Capital = Current Assets -Current Liabilities
Higher working capital turnover ratio is always better. Higher working capital indicates that the company uses its working capital very efficiently.
The low working capital ratio is an indicator that the company is not operating optimally.
Also read Capital Markets: Definition, Types and Examples .
4. Fixed Asset Turnover (Working Capital Turnover)
Fixed assets measure the turnover ratio of the company’s long-term capital investment efficiency. It reflects the level of sales generated by investments in productive capacity . The fixed asset turnover formula is:
Fixed Asset Turnover = Average Sales/Fixed Assets
Interpreting the fixed asset turnover ratio is tricky. This is because this ratio is affected by many circumstances such as company life cycle, product life cycle, initial plant capacity & relative sales. Also, there are factors such as valuation of assets ( accounting of depreciation ), while the purchase of company assets, etc. which affect this ratio. So all in all, the higher the total asset turnover, the better.
5. Total Assets Turnover (Fixed Assets Turnover)
This ratio provides a measure of overall investment efficiency by summing the combined impact of short-term and long-term assets. The ratio can be calculated as follows:
Total Asset Turnover = Sales/Average Total Assets
Like the fixed asset turnover ratio, the total asset turnover ratio is also affected by similar factors.
All things being equal, higher asset turnover is better because it shows how effectively all funds (Assets = Capital + Liabilities) of the company are being used. It is a holistic measure of company equity.
Also read What is Diversification In Investment And Asset Class .
Example of Efficiency Ratio
CISCO SYSTEM FINANCIAL SUMMARY
The following table represents a summary of Cisco Systems’ finances:
|SPECIAL||2008 (In MILLION Rupiah)||2007 (In MILLION Rupiah)|
|Cost of goods sold||14.056||12,586|
|Accounts Receivable Average||(3.821+3.989)/2=3.905|
|Average Accounts Payable||(869+786)/2=827.50|
|Smooth Obligations (A)||13,858||13,358|
|Current Assets (B)||35,699||31,574|
|Working Capital (B)-(A)||35,699-13,858=21,841||31,574-13,358=18,216|
|Average Working Capital||(21.841+18.216)/2=20.028.5|
|Average Fixed Assets||(4.151+3.893)/2=4.022|
|Average Total Assets||(58,734+53,340)/2=56,037|
With the help of the above summary, we have calculated the efficiency ratio and it is presented as below. This will give a fair idea of how to calculate the efficiency ratio.
|RATIO CALCULATION IN 2008|
|Accounts Receivable Turnover||Sales Receivable/Average||39,540/3.905||10.13|
|Average Number of Days Receivable Extraordinary||365/Receivable Turnover||365/10.13||36.03 Days|
|Inventory Turnover||Cost of Goods Sold/Average Inventory||14,056/1278.5||11|
|Average Number of Days Inventory in Stock||365/Inventory Turnover Ratio||365/11||33.18 Days|
|Accounts Payable Turnover||Total Purchases/Average Accounts Payable||13,969/827.50||16.88|
|Average Number of Days Outstanding Debt||365/Debt Turnover||365/16.88||21.62 Days|
|Working Capital Turnover||Average Sales/Working Capital||39,540/20,028.5||1.97|
|Fixed Asset Turnover||Average Sales/Fixed Assets||39,540/4,022||9.83|
|Total Asset Turnover||Total Assets Sales/Average||39,540/56,037||0.71|
That’s all the information about the meaning of the efficiency ratio, types, examples and of course hopefully it will bring benefits to those of you who need it. And don’t forget to tell your family, relatives, friends and relatives.