What you’ll learn to do: Calculate ratios that indicate a company’s operating efficiency
By assessing a company’s use of credit, inventory, and assets, efficiency ratios can help small business owners and managers conduct business better. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given time period. This information can help management decide whether the company’s credit terms are appropriate and whether its purchasing efforts are handled in an efficient manner. Indicators of efficiency include:
- Inventory turnover and number of days’ sales in inventory that gauge how effectively a company manages its inventory.
- Accounts receivable turnover and number of days’ sales in receivables that look at the firm’s ability to collect its accounts receivable.
- Asset turnover ratio that indicates how efficient a company is at generating revenue from its assets.
There are some other, lesser known and lesser used efficiency measures as well, such as Inventory/Total Assets that shows the portion of assets tied up in inventory (generally, a lower ratio is considered better) and accounts payable turnover, and industry specific metrics, such as a special efficiency ratio for banks that is simply expenses divided by revenue. So, if a bank spent $5 billion and had revenues of $10 billion, its efficiency ratio would be 50%. The lower the efficiency ratio, the more efficient the bank is.