Efficiency ratios use financial data to analyze how effectively a company uses its resourcesto create revenue. This article provides details on how that works and simple formulas forsome of the most common efficiency ratios.
Inside this article:
- What efficiency ratios measure
- Top efficiency ratios
- How financial analysts use efficiency ratios
- Limitations of efficiency ratios
What Is an Efficiency Ratio?
An efficiency ratio is a metric that enables business leaders to measure how well a companyuses its resources. Managers may use these ratios to gain insights into where they canimprove operational, asset management and other business practices.
Experts sometimes also use the term "activity ratio" instead of efficiency ratio.
What Do Efficiency Ratios Measure?
Commonly used efficiency ratios compare a company's expenses with its revenue. Otherefficiency ratios measure how well a business maintains optimal inventory levels, or howquickly it collects money owed by customers. Which ratios a company uses depends on the typeof business and the areas in which managers think they can find efficiencies.
Key Takeaways
- Managers and analysts employ efficiency ratios to see how well a company uses its assetsand resources to produce revenue and profits while minimizing waste.
- A common efficiency ratio is the operating efficiency ratio, or operating ratio, whichcompares company operating expenses to net sales.
- Efficiency ratios can be helpful but shouldn't be used in a vacuum or as one-timeexercises. Managers need to analyze a range of financial data and should evaluateefficiency ratios over time.
How Is Efficiency Measured in Management?
Managers use efficiency ratios to understand how their companies are performing. By trackingapplicable efficiency ratios over time and looking for changes, they can adjust how thecompany operates to make it more efficient and spot and fix problems before they escalate.
Read our post on operations dashboards to learn how companies use software dashboards to helptheir managers and employees track some efficiency ratios.
Types of Efficiency Ratios
Efficiency ratios include those that track a company's expenses compared with revenues.Ratios also measure how effectively a company collects and spends its money and uses assets.
Here are some commonly used formulas.
Efficiency Ratio
A basic efficiency ratio tracks a company's expenses compared with itsrevenue. While many types of organizations use this ratio, it is particularly prevalent inthe banking industry.
The formula is:
Efficiency ratio = expenses/revenue
Operating Efficiency Ratio
The operating efficiency ratio and efficiency ratio are similar. The operating efficiencyratio shows how well a company uses the resources it spends to produce revenue. Experts usevarious terms for the same or similar ratios, including efficiency ratio, operationalefficiency ratio, operating efficiency ratio and operating ratio.
The formula is:
Operating efficiency or operating ratio = expenses (operating expenses, or OPEX + cost of goods sold, or COGS)/net sales
An accounting note: Some companies already include the cost of goods sold (COGS) in theiroperating expenses; others track the two expenses separately. For further explanation, readthis article about COGS and how to calculate it.
Accounts Receivable Turnover Ratio
This ratio tracks how well a company collects payments from customers for purchased productsor services within the expected deadline. Some people call it the “debtors'turnover” or the"receivable turnover" ratio.
The formula is:
Accounts receivable turnover ratio = netsales/average accounts receivable
Net sales is total sales in a specific period, minus returns. Calculate average accountsreceivable by using the accounts receivable figure at the start and end of a period and thendividing by two.
A higher accountsreceivable turnover ratio is better than a lower ratio. Companies can increase theirratios by selling more to financially stable customers and limiting credit to others. Often,a business will sell on credit and give their clients a set amount of time to pay, commonly30 days.
Average Collection Period
The average collection period relates to the accounts receivable turnover ratio. It shows theaverage number of days between when a company makes a sale to a customer on credit and whenthat customer pays. Companies track this number for various periods.
The formula is:
Average collection period = days inperiod company wants to track/accounts receivable turnover ratio during that period
Accounts Payable Turnover Ratio
Accounts payable turnover ratio tracks how quickly your company pays its suppliers or otherorganizations to which it owes money. The formula is:
Accounts payable turnover ratio = totalsupply or other purchases/average accounts payable
To calculate this ratio, track total supply purchases in a set period. Then add the accountspayable figure at the start of the period to the accounts payable figure at the end anddivide it by two. That provides your average accounts payable. Then, divide that number intototal supply purchases.
Track the accountspayable turnover ratio over time. A ratio that is decreasing shows a company takinglonger to pay debts and may indicate financial issues. An accounts payable turnover ratiothat is increasing shows the company may have enough cash to, for example, invest in R&Dorhiring.
Average Number of Days Payables Outstanding
The average number of days payables outstanding relates to the accounts payable turnoverratio. It represents the average number of days between when a company incurs a bill andwhen it pays that bill.
The formula is:
Average number of days payables outstanding = days in period to track/accounts receivable turnover ratio during that period
Inventory Turnover Ratio
The inventory turnover ratio tracks how quickly a company is selling products it has ininventory.
The formula is:
Inventory turnover ratio = cost of goodssold/average inventory
Track cost of goods sold over a specific period. Then, add the total inventory figure at thestart of the period and the number at the end and divide by two. The result is the averageinventory. Divide that figure into your cost of goods sold for the period.
A higher inventory turnoverratio signifies stronger sales. It also suggests the company manages stock well andisn’t spending too much money to store products that aren't selling
Well-run companies will focus on both inventory management andasset management, with assets meaning the equipment and supplies a company usesinternally.
Days Sales in Inventory
Days sales in inventory relates to the inventory turnover ratio. The ratio tracks how manydays it takes for a company to turn its inventory into a completed sale.
The formula is:
Days sales in inventory = (averageinventory/cost of goods sold) X 365
A lower days sales in inventory figure is better because it shows that a company is sellingits stock quickly. That result indicates both good sales and lower inventory costs.
Asset Turnover Ratio
One of many asset or asset management efficiency ratios, the asset turnover ratio representshow a company uses its assets to drive revenue and sales. Experts sometimes call this thetotal asset turnover ratio.
The formula is:
Asset turnover ratio = net sales/averagetotal assets
Net sales is all the sales in a period minus returns and sales allowances. To find averagetotal assets, add the total assets at the start of a period and the total assets at the endof a period and divide by two.
A higher asset turnover ratio is better than a lower one and shows the company generates morerevenue based on the assets used to garner that revenue.
Fixed Asset Turnover Ratio
Fixed asset turnover ratio is like the asset turnover ratio, except it considers onlylonger-term fixed assets. The ratio focuses on how a company generates sales based on fixedassets like manufacturing plants, machinery and equipment.
The formula is:
Fixed asset turnover ratio = netsales/average fixed assets
As with the total asset turnover ratio, a higher ratio is better because that means thecompany uses its fixed assets well — to generate more revenue.
Total Assets to Sales
Total assets to sales is simply a reverse way of looking at the asset turnover ratio.
The formula is:
Total assets to sales = totalassets/sales
Fixed Assets to Total Assets
The fixed assets to total assets ratio provides insights into the percentage of a company'stotal assets based on its plant, equipment and machinery and similar assets.
The formula is:
Fixed assets to total assets = fixedassets/total assets
Company assets that aren't fixed are current assets, such as inventory and accountsreceivable. For many companies, the fixed assets/total assets ratio will be 50% or greater.
Working Capital Ratio
Experts sometimes call this ratio the "current ratio." The working capital ratio shows howeasily a company could pay off its current liabilities with its current assets.
The formula is:
Working capital ratio = currentassets/current liabilities
In general, experts consider that a working capital ratio of less than one shows a strugglingcompany. A working capital ratioof 1.5 to 2 indicates a healthy balance sheet.
Formulas for Efficiency Ratio
Efficiency Ratios
| Ratio | Formula |
|---|---|
| Efficiency Ratio | Efficiency ratio = expenses/revenue |
| Operating Efficiency or Operating Ratio | Operating efficiency or operating ratio = expenses (operating expenses +COGS)/net sales |
| Accounts Receivable Turnover Ratio | Accounts receivable turnover ratio = net sales/average accountsreceivable |
| Average Collection Period (non-ratio metric related to accountsreceivable turnover ratio) | Average collection period = days in period to track/accounts receivableturnover ratio during period |
| Accounts Payable Turnover Ratio | Accounts payable turnover ratio = total supply or otherpurchases/average accounts payable |
| Average Number of Days Payables Outstanding (non-ratio metric related toaccounts receivable turnover ratio) | Average number of days payables outstanding = days in period totrack/accounts receivable turnover ratio during period |
| Inventory Turnover Ratio | COGS/average inventory |
| Days sales in inventory (non-ratio metric related to inventory turnoverratio) | Days sales in inventory = (average inventory/COGS) X 365 |
| Asset Turnover Ratio | Asset turnover ratio = net sales/average total assets |
| Fixed Asset Turnover Ratio | Fixed asset turnover ratio = net sales/average fixed assets |
| Total Assets to Sales | Total assets to sales = total assets/sales |
| Fixed Assets to Total Assets | Fixed assets to total assets = fixed assets/total assets |
| Working Capital Ratio | Working capital ratio = current assets/current liabilities |
Operational Efficiency Ratios
The operating ratio, or operational efficiency ratio, indicates how well your company isperforming. A lower ratio is better; it shows your company is spending less money togenerate more revenue. A ratio that decreases over time reveals a company that is learninghow to trim expenses and therefore increase profits. This ratio can help a company toimprove operational efficiency.
What Is a Good Operating Efficiency Ratio?
Experts consider many factors when interpreting a company's operating efficiency ratio. Theylook at the company’s industry and evaluate how the company's competitors are doing.
Financial industry analysts commonly use the efficiency ratio to judge a bank’sperformance.Experts consider an efficiency ratio of 50% or less to be extremely good. The averageefficiency ratio for banks is closer to 60%.
For companies in other industries, a "good" operating efficiency ratio will vary. Experts payattention to how a business is doing compared with competitors and see if the ratio improvesover time.
Operating Efficiency Ratio vs. Operating Expense Ratio
Managers shouldn't confuse the operating efficiency ratio with the operating expense ratio,which is a calculation the real estate industry uses to measure the costs for a rentalproperty compared with how much the property makes.
Real estate experts use that ratio to compare the value of different rental properties. Asindicated above, the operating efficiency ratio is used more broadly across industries. Itcompares a company's total expenses to its total revenue.
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Challenges With the Operating Ratio and Other Ratios
Managers should consider context as they analyze a company's operating ratio or other ratios.In particular, leaders must look at the operating ratio along with other financial numbersand watch efficiency ratios over time.
For example, in addition to the operating ratio and other efficiency ratios, look atimportant financial data like:
- The ratio of the company's debt to its equity
- The gross profit margin for products it sells
- The organization's free cash flow in recent periods
Other challenges of working with operating ratios include:
- The operating ratio or operating efficiency ratio doesn't track a company's debt. Abusiness might have substantial debt, which will require payments from the companymonthly. But it may have the same operating ratio as a company with no debt. That's whyanalysts consider a range of financial data in analyzing companies.
- Leaders should also review a company's operating ratio over time to pick up on trends ormajor changes in a given timeframe. A business can cut costs in one period and itsoperating ratio will look better. But the organization may need to add those costs backin later periods to operate the business.
- Operating ratios can vary significantly by industry. When comparing companies or judginghow a company is doing, compare operating ratios with similar businesses in the sameindustry.
- Companies may use nonstandard accounting methods that affect some of the variables inthese ratios. That may make it difficult, or misleading, to compare two companies— evenin the same industry.
- Organizations can work to change the numbers that fit in an efficiency ratio simply tomake that ratio look good. Those changes don't indicate a healthy company, even if theratio looks good.
- Focusing too much on any one efficiency ratio can hurt the company overall. A businessthat wants to produce a positive fixed asset turnover ratio, for example, may decideagainst investments that should happen for the long-term benefit of the company. Or, onethat wants to produce a positive inventory turnover ratio might stock inventory items insuch low quantities that the company doesn't have products available for customers whowish to buy them.
How Efficiency Ratios Are Used in Financial Analysis
Analysts use the operating ratio and other efficiency ratios to judge the financial health ofcompanies. The operating ratio is a common way to benchmark performance, but experts look atother efficiency ratios as well.
Efficiency ratios can be solid measurements of a company's ability to generate income fromits assets. Financial analysts may also track the ratios over time to see how a business istrending in its operations. They can use efficiency ratios to compare the health, and thequality of management, of companies in the same industry.
Financial analysts use efficiency ratios because there is a direct correlation between solidnumbers and profitability.
An Example of How Technology Can Help Operational Efficiency
ReSource POS improved its operational efficiency and grew its business by using acustomizable enterprise resource planning (ERP) solution. TheERP helped improve how the company dispatched technicians and tracked work orders. Itachieved a return on investment in three months through better revenue capture documentationand accurate job quotes. Additionally, dispatchers were able to manage technicians moreefficiently. Learn more about how the ERP helped ReSource POS improve its operations(opens innew tab).
NetSuite's Systems Deliver Invaluable Insight Into Your Own Financial Data
Calculating operating efficiencies starts with having accurate data to pinpoint operationalareas that may need improvement. NetSuite goes beyond collecting basic financial metrics.Its financial reportingsystem helps you track statistical and operational data to enable a comprehensiveview of your business. NetSuite provides real-time operational, tactical, and strategicintelligence in a simple system. And its SuiteAnalytics featurehelps you discover hidden information in your financial data that gives you meaningfulinsights and helps you make critical decisions.
