Efficiency Ratios

Efficiency ratios are a set of key performance indicators that demonstrate a business’s ability to generate revenue out of its asset resources. These ratios give an indication of how efficient a business is utilizing its resources in its operations. In this category of ratios, comparisons are made among the sales revenue, average total assets, average inventory, average accounts receivable and average accounts payable numbers.

The four most commonly used efficiency ratios are the total asset turnover ratio, inventory turnover ratio, accounts receivable ratio and accounts payable turnover ratio. Usually, it is recommended to calculate an average balance for your assets because they would fluctuate during the financial year. It is also acceptable to use closing balances too.

Total Asset Turnover Ratio = Sales Revenue / [Opening Assets + Closing Assets]/2

The total asset turnover ratio indicates how efficiently a business is using its assets to generate sales. Usually, the higher the ratio, the better the utilization of the assets. This ratio can also be analyzed by using the fixed assets numbers from your balance sheet if you want to specifically know how efficiently your business’s fixed assets are being used.

Inventory Turnover Ratio = Cost of Sales / [Opening Inventory + Closing Inventory]/2

expressed in days = 365 / Inventory Turnover Ratio

The inventory turnover ratio is an indicator of how long inventory has been sitting on your shop floor or in your warehouse prior to being sold.  If you run a retail business, you would want this ratio to be high and in your favour. This ratio can also indicate whether you have to restock your shelves frequently or not. Carrying too low levels of inventory can be dangerous if you are unable to meet unexpected surges in customer demand. At the opposite end of the spectrum, holding inventory for too long before selling it can potentially mean that your money is tied up unnecessarily in an asset that is not earning a return.

Accounts Receivable Turnover Ratio = Sales Revenue / [Opening Accounts Receivable + Closing Accounts Receivable]/2

expressed in days = 365 / Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures the average length of time that a customer takes to pay you. It shows how quickly or slowly a sale is converted into cash that is deposited in your bank account. Each industry will have their own standard of acceptable credit payment terms. This ratio should be analyzed to ensure that your customers are not taking longer than the acceptable industry standard to settle their outstanding accounts with you.

 Accounts Payable Turnover Ratio = Cost of Sales or Inventory Purchases  / [Opening Accounts Payable + Closing Accounts Payable]/2

expressed in days = 365 / Accounts Receivable Turnover Ratio

The accounts payable turnover ratio tells us how long a business takes to pay its suppliers and vendors. Paying too soon can mean that your business is not taking advantage of the suppliers credit terms. The money that is used to pay your suppliers is leaving your bank account too soon when it could have earned a few more days of interest for your business. However, if your supplier grants you favorable discounts for paying early, it makes sense to settle your accounts early. In addition, this also creates a positive rapport and reputation with your vendors who would be more willing to give favourable references to other vendors in the supply chain to extend credit to your business. A longer period of settlement is good as long as you are never late with your payments. An unhappy vendor in your supply chain can make life difficult.

The sweet spot when it comes to managing your business’s cash flow is to collect your cash from your customers as soon as possible while paying your vendors as close to their due date as you can possibly can.