How to Use Efficiency Ratios to Assess a Company’s Financial Health?

Fundamental analysis involves a deep dive into assessing a company’s financial standing. Here’s where operational efficiency ratios come into play. Simply put, efficiency ratios are metrics that are used in analyzing a company’s ability to effectively employ its resources to generate income.

The ratios serve as a comparison of expenses made to revenues generated. Essentially, it reflects what kind of return in revenue or profit a company can make from the amount it spends to operate its business.

What is the Efficiency Ratio?

The Efficiency Ratio offers a good comparison between different companies in the same sector. There is a high correlation between efficiency ratios and profitability ratios. When companies efficiently allocate their resources, they become profitable.

Let’s understand how to use efficiency ratio, what are efficiency ratio formula and how it can help assess a company’s financial health.

• Inventory Turnover Ratio

You might be wondering, “What does Inventory Turnover Ratio indicate?”. The answer to that is pretty simple. The Inventory Turnover ratio is the number of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any set period of time.

A high Inventory Turnover Ratio indicates that goods are sold faster. And a low turnover rate indicates weak sales and excess inventories, which may be challenging for a business.

• Inventory Turnover Ratio = (Cost of Goods Sold) / (Average Inventory)

The cost of goods sold includes expenses such as raw materials and labour costs.

Average inventory is the average cost of a set of goods during two or more time periods. It takes into account the beginning inventory balance at the start of the fiscal year. This plus the ending inventory balance of the same year.

Example: ABC has a cost of goods sold of Rs. 50 crores for the current year. The company’s cost of beginning inventory was Rs 6 crores and the cost of ending inventory was Rs 4 crores. Given the inventory balances, the average cost of inventory during the year is calculated at Rs 5 crores. As a result, inventory turnover is rated 10 times a year.

You may also want to read: 5 Financial Ratios Every Stock Investor Should Know

• Asset Turnover Ratio

The Asset Turnover Ratio is an Efficiency Ratio that measures a company’s ability to generate sales from its assets. This is by comparing net sales with average total assets. In other words, this ratio shows how efficiently a company can use its assets to generate sales.

The Total Asset Turnover Ratio calculates net sales as a percentage of assets. This is to show how many sales generate from each rupee of company assets. For instance, a ratio of 0.5 means that each rupee of assets generates 0.5 Rs of sales. The Asset Turnover Formula is as follows:

• Asset Turnover Ratio = Net Sales / Average Total Assets

Net sales, from the income statement, are used to calculate this ratio. Returns and refunds are excluded from total sales to truly measure the firm’s assets’ ability to generate sales.

Average Total Assets are usually calculated by adding the beginning and ending total asset balances together and dividing them by two.

Higher Turnover Ratios mean the company is using its assets more efficiently. Lower ratios mean that the company isn’t using its assets efficiently and most likely have management or production problems.

Average inventory is the average cost of a set of goods during two or more time periods. It takes into account the beginning inventory balance at the start of the fiscal year. This plus the ending inventory balance of the same year.

• Accounts Payable Turnover Ratio

The Accounts Payable Turnover ratio is also known as the Payables Turnover or the creditor’s Turnover Ratio. It is a liquidity ratio that measures the average number of times a company pays its creditors over an accounting period.

The ratio is a measure of short-term liquidity. If the turnover ratio declines from one period to the next, this indicates that the company is paying its suppliers more slowly. And may indicate a worsening financial condition.

A change in the turnover ratio can also indicate altered payment terms with suppliers, though this rarely has more than a slight impact on the ratio.

If a company is paying its suppliers very quickly, it may mean that the suppliers are demanding fast payment terms, or that the company is taking advantage of early payment discounts. The Accounts Payables Turnover Formula is as follows:

• Accounts Payables Turnover Ratio = net credit purchases/average accounts payables. 

In some cases, the cost of goods sold (COGS) is in the numerator in place of net credit purchases. Average accounts payable is the sum of accounts payable at the beginning and end of an accounting period, divided by 2.

• Accounts Payables Turnover in Days

The accounts payable turnover in days shows the average number of days that a payable remains unpaid. To calculate the accounts payable turnover in days, simply divide 365 days by the payable turnover ratio.

• Payable turnover in days = 365 / Payable turnover ratio

• Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio is the number of times per year that a business collects its average accounts receivable.

The ratio is to evaluate the ability of a company to efficiently issue a credit to its customers and collect funds from them in a timely manner.

A high turnover ratio indicates a combination of a conservative credit policy. It also indicates an aggressive collections department, as well as a number of high-quality customers.

A low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital.

Low receivable turnover may be due to a loose or non-existent credit policy, inadequate collection function, and/or a large proportion of customers having financial difficulties.

It is also quite likely that a low turnover level indicates an excessive amount of bad debt. It is useful to track accounts receivable turnover on a trend line in order to see if turnover is slowing down. If yes, an increase in funding for the collections staff may be a requirement. Alternatively, a review is required to understand why turnover is worsening.

• Accounts Receivables Turnover Ratio=Net Credit Sales/Average Accounts Receivables

The accounts receivable turnover in days shows the average number of days that it takes a customer to pay the company for sales on credit. The formula for the accounts receivable turnover in days is as follows:

• Receivable turnover in days = 365 / Receivable turnover ratio

Happy Investing!

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.