In the last two articles, I discussed profitability, market, liquidity and leverage ratios. In this article I will be discussing efficiency ratios.
Efficiency ratios measure the ability of a firm to employ its resources efficiently to generate income. There is high correlation between efficiency ratios and profitability ratios.
If a firm has improved its efficiency ratios over time, this could indicate that the company has become more profitable.
- Read: Financial Ratios: Liquidity and Leverage Ratios
- Visit Investogist’s homepage for more articles
Inventory turnover: measures the number of times a company bought and sold its stocks within a given period. In general terms, the higher the inventory turnover ratio, the lower the capital tied up in inventories and the more efficient the managers are in selling inventory rapidly.
Inventory turnover ratio = Cost of goods sold/Average inventory
Average inventory is calculated by dividing the sum of the beginning inventory and ending inventory by two.
Inventory turnover ratio can also be calculated using revenue instead of cost of goods sold but the later gives more accuracy.
Accounts receivables turnover ratio: measures how efficiently a company extends credit and collects its debts. A high receivables ratio compared to its industry peers shows that a company is more efficient than its competitors in collecting its debts when due. The ability of a company to collect cash sooner form customers will improve its cash flow as well.
The receivables turnover ratio of firm should be monitored to determine if a trend or pattern is developing.
Receivables turnover ratio = Net credit sales / Average accounts receivable
Net credit sales = sales revenue – returns from customers
Average accounts receivable is the sum of starting and ending accounts receivables over a given period divided by two.
Accounts payable turnover ratio: measures how quickly a business pays its creditors during the accounting period. The higher the result, the longer the company is taking to pay its suppliers.
Net credit purchases = Net credit purchases/average accounts payable
Since the number for net credit purchases and net credit is often not available, analysts often substitute COGS as the numerator instead.
Average accounts payable is the sum of starting and ending accounts payable over a given period divided by two.
Asset turn over period: this ratio measures the ability of a company to generate sales revenue from its assets. A high value implies that the management of the company is utilizing the company assets effectively while a low value implies inefficient use of assets.
Asset turnover ratio = Revenue / Average total assets
Average total asset is the sum of starting and ending total assets over a given period divided by two.
In conclusion, financial ratios are important metrics used by managers to evaluate the operations of a business. On the hand, investors and lenders use these ratios to analyse the health of a company and decide whether the business presents a good investment opportunity or the level of risk involved.
Ifunanya Ikueze is an Engineer, Safety Professional, Writer, Investor, Entrepreneur and Educator.
