Efficiency ratios look at how well a company utilises and controls its assets as well as manages its liabilities. Businesses in all industries must invest in assets to perform operations. Although there are numerous ratios one could look at, we’ve selected 5 commonly used efficiency ratios.
Accounts Receivable Turnover:
Accounts receivable turnover ratio looks at the relationship between total monthly sales and accounts receivable ie. Unpaid sales. A ratio nearing 1.0 is considered high as it means that the business has not received the cash for a significant portion of total sales. Ie it is tied up with slow paying clients. This may indicate credit terms that are too lenient.
Total accounts receivable / Total sales (in a specific accounting period)
Accounts Payable to Sales Ratio:
This ratio looks at the relationship between accounts/suppliers that have not yet been paid and the total sales revenue for a specific period. The ratio is considered high if it nears 1.0 and may be an indication of liquidity problems. Ie. The company is using credit granted by suppliers to finance business operations. A low number on the other hand would indicate a healthy ratio,
Total Accounts Payable / Net Sales
Sales to Inventory Ratio:
This ratio looks at the relationship between investment in inventory and monthly sales. Inventory is the amount of merchandise or supplies that a business keeps in stock to meet the demands of its customers. This ratio will differ depending on the type of business one is in ie. retail, wholesale, service or manufacturing and hence needs to be compared with ratios of other businesses in the same industry. An increasing number may mean that a businesses’ investment in inventory is growing more rapidly than sales or that sales are dropping (business may be under stocked in relation to other suppliers). Conversely if the inventory to sales ratio decreases it may mean that your investment in inventory is shrinking in relation to sales or that your sales are increasing.
Inventory / Sales for the month
Fixed Asset Turnover
Fixed asset turnover looks at the relationship between sales and the value of fixed assets. It can assist a business owner in determining how well fixed assets (such as machinery, property or specialised equipment) are being used to generate sales. A high or increasing ratio indicates that the business has less money tied up in fixed assets for each sale generated – which is generally a good thing. A low or declining ratio could mean that the business has invested heavily in fixed assets such as machinery or equipment.
Sales / Net Fixed Assets
Collection Period Ratio
By looking at the average time period (in days) for which receivables are outstanding, this ratio helps to determine the efficiency of a company’s credit policy and debt collection processes. Every company has different credit terms and so this ratio should be used in-house to monitor what is acceptable and what is not.
Accounts Receivable ÷ Sales x 365 Days
Next month we’ll look at Profitability Ratios…