What Do Efficiency Ratios Measure?

Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively. Although there are several efficiency ratios, they are all similar in that they measure the time it takes to generate cash or income from a client or liquidating inventory. Efficiency ratios include the inventory turnover ratio, asset turnover ratio, and receivables turnover ratio. These ratios measure how efficiently a company uses its assets to generate revenues and its ability to manage those assets. With any financial ratio, it's best to compare a company's ratio to its competitors in the same industry.

The inventory turnover ratio measures a company's ability to manage its inventory efficiently and provides insight into the sales of a company. The ratio measures how many times the total average inventory has been sold over the course of a period. Analysts use the ratio to determine if there are enough sales being generated to turn or utilize the inventory. The ratio also shows how well inventory is being managed including whether too much or not enough inventory is being bought.

The ratio is calculated by dividing cost of goods sold by the average inventory.

For example, suppose company ABC sold computers and reported the cost of goods sold (COGS) at $5 million. The average inventory of ABC is $20 million. The inventory turnover ratio for ABC is 0.25 ($5 million/$20 million). This indicates that company ABC is not managing its inventory properly because it only sold a quarter of its inventory for the year.

The asset turnover ratio measures a company's ability to generate revenues from its assets efficiently. In other words, the asset turnover ratio calculates sales as a percentage of the company's assets. The ratio is effective in showing how many sales are generated from each dollar of assets that a company owns. A higher asset turnover ratio means the company's management is using its assets more efficiently while a lower ratio means that the company's management isn’t using its assets efficiently.

The ratio is calculated by dividing a company's revenues by its total assets. For example, suppose a company had total assets of $1,000,000 and sales or revenue of $300,000 for the period. The asset turnover ratio would equal .30, ($300,000/$1,000,000). In other words, the company generated 30 cents for every dollar in assets.

The receivables turnover ratio measures how efficiently a company can actively collect its debts and extend its credits. The ratio is calculated by dividing a company's net credit sales by its average accounts receivable.

For example, a company has an average accounts receivables of $100,000, which is the result after averaging the beginning balance and ending balance of the accounts receivable balance for the period. The sales for the period were $300,000, so the receivable turnover ratio would equal 3, meaning the company collected their receivables three times for that period.

Typically, a company with a higher accounts receivables turnover ratio, relative to its peers, is favorable. A higher receivables turnover ratio indicates the company is more efficient than its competitors when collecting accounts receivable.