Efficiency ratios show how well a business is converting assets and liabilities into profitable activities. Since profit is the name of the game, it is important to regularly analyze these four ratios.
What Is an Efficiency Ratio?
Efficiency ratios, also called activity ratios, measure how well a company utilizes its assets to generate income. These ratios help management improve the profitability of the company and help investors and creditors better understand operations.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures how many times a business can turn its accounts receivables into cash over a specific time period. A higher number indicates higher efficiency. Calculate the accounts receivable turnover ratio by dividing net credit sales by average accounts receivable.
For example, the beginning accounts receivable is $10,000. The company has $75,000 of gross credit sales, $25,000 of returns, and the ending accounts receivable balance is $20,000. The accounts receivables turnover is:($75,000 – $25,000) / $15,000 = 3.33
Working Capital Ratio
The working capital ratio, also called the current ratio, measures the ability for a company to pay off its current liabilities with its current assets. In all cases, a higher ratio is better, and any value lower than 1 indicates the business can’t meet its short-term debt requirements. You can figure out the working capital ratio by dividing the current assets by the current liabilities. For example, if the working capital ratio is 3, the company has $3 available for every dollar in current liabilities, which is a healthy position.
Asset Turnover Ratio
The asset turnover ratio measures a company’s ability to generate sales from its assets. Divide the net sales by the average total assets to calculate the asset turnover ratio.
For example, assume a company has $250,000 in sales and $500,000 of average total assets. In this case, the ratio would equal 0.5. You can interpret this as meaning that each dollar of assets generated 50 cents of sales. Generally, a higher asset turnover ratio is better.
Inventory Turnover Ratio
The inventory turnover ratio measures how effectively inventory is managed over a period of time. It measures how many times a company sold its total inventory over the time period. It shows how well the company is managing its product purchases, and it helps identify the velocity of sales. Calculate the inventory turnover ratio by dividing the cost of goods sold by the average inventory.
For example, a company’s inventory at the beginning of the month was $100,000. At the end of the month, inventory was $40,000 and the cost of goods sold throughout the month was $350,000. The inventory turnover would be:$350,000 / $70,000 = 5
Turnover varies across industry, so it is difficult to say that higher or lower is better. Overall, the inventory turnover ratio is an important metric to measure regularly. Often, small businesses put inventory up as collateral, and creditors want to see that the products are moving off the shelves quickly.