6 efficiency ratios and how to calculate them (plus FAQs)
By Indeed Editorial Team
Updated 12 September 2022
Published 30 April 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
In fields of work like business analysis, accounting and finance, there are various ways of measuring performance and efficiency. Efficiency ratios are among the ways of measuring how optimally a company is using its assets. If you're interested in understanding what makes a business efficient, knowing how to calculate some of these ratios can be useful. In this article, we explain what efficiency ratios are, how to calculate six different types of ratios and answer some frequently asked questions.
What are efficiency ratios?
Efficiency ratios are analytical tools that help you to measure the effectiveness of a business and how it uses its assets. This is indicative of the company's ability to turn its assets into income in the short term. An asset is something on a company's balance sheet that has positive value for the business, such as cash, real estate, machinery, inventory and even intellectual property. A company's income is the money it can generate through business activities and is on its financial statements. Efficiency means how effectively it turns these assets into income.
For example, assume that two businesses have the exact same assets. The first company is able to generate £1,000 in income from these assets. The second company is able to generate £1,500 in income from the same assets. This means that the second company is 50% more efficient than the first one. These ratios are interesting to accountants, analysts and investors, among others.
6 efficiency ratios
There are various types of ratios that can measure efficiency. Many of them focus on a specific kind of asset and how efficient its usage is. Below are six important ratios, what they mean and how you can calculate them:
Total asset turnover
The total asset turnover ratio measures profitability. Specifically, this means how many pounds in income the business can generate from one pound in assets. Since this is the total asset turnover ratio, you use all of the company's assets in the calculation. These are going to vary significantly from one business to another. For instance, a real estate company might have a lot of fixed assets in the form of land and property. Conversely, an online software developer might have very few assets beyond computer hardware, especially if it rents office space.
This ratio uses average assets rather than total assets at any given time. This is because assets can change over time. You can calculate the average by adding the value of assets at the beginning of the year to the value of assets at the end of the year and dividing this figure by two. The higher the number, the better the performance. The asset turnover ratio's formula is as follows:
total asset turnover ratio = net sales / average total assets
This is a more specific ratio that looks at how effectively a business sells its inventory. The two variables that it considers are the average value of a company's inventory over the course of a year and the cost of the sold goods. This can tell you how often the business is able to sell its whole inventory and is a good indicator of how well the business manages supply and demand. Remember that inventory is the stock of goods a company keeps, including finished goods and raw materials.
Average inventory is the value at the beginning of the year plus the value at the end of the year, then dividing this figure by two. Cost of goods sold (COGS) includes material, labour and distribution costs, but excludes marketing, sales and overhead costs. This is also the figure that you subtract from revenue to get a gross profit figure. The higher the inventory turnover ratio is, the better. The formula for calculating the inventory turnover ratio is as follows:
inventory turnover ratio = cost of goods sold (COGS) / average inventory
A bank efficiency ratio is useful for financial sector companies like credit unions and banks. Unlike many other ratios, a lower figure is indicative of better performance in this case. These institutions can use this ratio to compare their net revenues to their operating expenses, which can be a good measure of profitability and liquidity. The formula for the bank efficiency ratio is as follows:
bank efficiency ratio = operating expenses / net revenues
Accounts receivable turnover
The accounts receivable ratio compares a company's net credit sales to its average accounts receivable. A credit sale is where customers acquire products but pay for them at a later date without interest. This ratio demonstrates how effective the company is at collecting money that customers or clients owe. A higher ratio would therefore indicate that the company is quite good at doing this. The average accounts receivable is a figure you can calculate by adding the figure at the beginning of the year to the figure at the end of the year and then dividing the total by two.
This ratio can also indicate how effectively the company can identify customers who are going to pay back on time. The finance department might be interested in calculating this regularly and even comparing it to competitors. The formula for the accounts receivable turnover ratio is as follows:
accounts receivable turnover ratio = net credit sales / average accounts receivable
Accounts payable turnover
This ratio is effectively the opposite of the accounts receivable one. The accounts payable turnover ratio measures how effectively a business can repay its suppliers. Accounts payable refers to short-term debt obligations where a company purchases goods from suppliers but pays at a later date. The accounts payable ratio demonstrates how regularly the business is able to pay its suppliers and creditors and is also an indicator of liquidity. The higher this ratio is, the more regularly the company pays its creditors.
This ratio is quite important because consistent irregularity in these payments can lead to higher interest rates, which would increase company costs. You get the figure for average accounts payable by adding the value at the beginning of the year to the value at the end of the year and then dividing the total by two. The formula for calculating the accounts payable turnover ratio is as follows:
accounts payable turnover ratio = net credit purchases / average accounts payable
Day sales in inventory (DSI)
This is a ratio that demonstrates how long it takes a company to turn its inventory into sales. Other names for this include the 'average age of inventory', 'days in inventory (DII)' and 'days inventory outstanding (DIO)'. The figure that you calculate is therefore the number of days that a company's current inventory stocks are going to last. Since high turnover is desirable in this regard, a lower figure is preferable for this ratio in most cases, but if it's too low this can indicate that there are supply problems.
There are two versions of this ratio, depending on the accounting practices at the organisation. One version is to use the average inventory figure, which is the sum of the beginning and end values for a specified period divided by two. This version shows the DSI for that period. If you want to get the value for a certain point in time, simply use the relevant ending inventory value. The two formulas for calculating days in inventory are as follows:
DSI ratio = (average inventory / cost of goods sold) x 365
DSI ratio = (ending inventory / cost of goods sold) x 365
Frequently asked questions about ratios
Below are some frequently asked questions about ratios, together with their respective answers:
What's the difference between efficiency ratios and leverage ratios?
An efficiency ratio typically demonstrates how effectively a business is using its assets. A leverage ratio is an indicator of the levels of debt that a company has accumulated in relation to its accounts. These accounts could be in their income statements, balance sheet or cash flow statements. For instance, the debts-to-assets ratio is a measure of total debts divided by total assets. The higher this number is, the greater the proportion of liabilities to assets the company has, which could indicate a higher risk of default.
What's the difference between efficiency ratios and profitability ratios?
A profitability ratio is a measure of a company's ability to generate income relative to its assets, costs, equity or revenue. A simple and relatively common example of this is the gross profit margin, which shows the level of gross profit relative to sales revenue. Profitability ratios are often measured at a specific point in time, whereas many efficiency ratios cover a time period like a year.
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