Efficiency Ratio: Types and Formula

What is the Efficiency Ratio?

As discussed, efficiency ratios (asset utilisation or operating efficiency ratios) measure how efficiently the firm manages its assets and resources. By efficiency, we mean how well assets generate sales and income. This category includes several ratios that indicate how well a firm utilises various assets, such as inventory and fixed assets. As a general thumb rule, higher efficiency indicates that the firm is better able to put its resources into use and thus indicates better growth potential. 

The following are some of the most frequently used efficiency ratios that will help you assess the growth potential of a company:

• Accounts Receivable Turnover Ratio

This ratio reflects how fast the company collects cash from customers to whom it offers credit. Although limiting the numerator to sales made on credit would be more appropriate, credit sales information is usually unavailable to investors. Therefore, revenue reported in the income statement is generally used as an approximation.

Formula: 

Receivables turnover ratio = Annual sales / Average receivables 

Interpretation of the ratio:

A high receivables turnover ratio could result from doing an excellent job of managing credit terms and collections. It also indicates that a company has stringent credit terms, offers a significant discount for early payment, or charges high penalties for late payment. A company that has excessively stringent credit terms might lose sales as a result.

Insight into why a company has a high receivables turnover rate can be gained by looking at the company’s revenue growth compared to that of its peers. Slower growth could indicate that credit terms may be too stringent. In contrast, a high receivables turnover and revenue growth at or above the peer group average could indicate superior credit terms and collections management.

The inverse of the receivables turnover ratio times 365 helps us arrive at the average collection period, or days of sales outstanding [DSO], which is the average number of days it takes for the company’s debtors to pay their dues.

Formula:

Days of sales outstanding = 365 / Receivables turnover ratio 

• Inventory Turnover Ratio 

Inventory turnover measures a firm’s efficiency concerning its processing and inventory management. It measures the number of times it sells and replaces its average inventory in a specific period. In other words, by calculating this ratio, an investor can gain insights into how quickly the company can sell its inventory and replace it with the new inventory. 

Formula: 

Inventory Turnover Ratio = Cost of goods sold / Average inventory 

Interpretation of the ratio:

• High inventory turnover indicates effective inventory management. But it could also result from holding inventory levels that are too low so that sales are lost when orders cannot be filled immediately. 
• A low inventory turnover ratio relative to peers could indicate that some inventory is obsolete and is slow-selling. Holding too much inventory can also lead to higher costs behind inventory management. Moreover, in the case of perishable goods, it may indicate higher operational risk too. In either case, examining revenue growth relative to peers can provide more insight into whether inventory is well or poorly managed.

The inverse of the inventory turnover ratio times 365 is the average inventory processing period, the number of days of inventory, or days of inventory on hand:

Formula:

Days of inventory on hand = 365 / Inventory turnover ratio

• Payables Turnover Ratio

The ratio measures the firm's efficiency in managing its creditors. It calculates the number of times the company pays its creditors (trade payables) during a period. This ratio is essential to calculate as you get an idea of the terms of the relationship between a company and its creditors. 

Formula:

Payables turnover ratio = Purchases / Average trade payables 

Interpretation of the ratio:

• A high payables turnover ratio relative to peers may either indicate that a company is not fully taking advantage of supplier credit terms or is paying suppliers early to take advantage of discounts. 
• A payables turnover rate that is low relative to that of peer companies may indicate that a company is having problems with short-term cash flows or, alternatively, that a company is simply taking advantage of lenient terms negotiated with suppliers due to its scale of operations. 

The inverse of the payables turnover ratio multiplied by 365 is the payables payment period or number of days of payables, which is the average amount of time it takes the company to pay its creditors:

Formula:

Number of days payables = 365 / payables turnover ratio 

• Total Assets Turnover Ratio

The effectiveness of the firm’s use of its total assets to create revenue is measured by its total asset turnover ratio. It is a measure that tells investors how well the company's assets are being used to generate sales. 

Turnover ratios vary from industry to industry. A capital-intensive manufacturing business might have asset turnover ratios near one, while retail businesses might have turnover ratios near 10. Just like any other ratio, it is desirable for the total asset turnover ratio to be close to the industry norm. 

Formula:

Total assets turnover ratio = Revenue / Average total assets 

Interpretation of the Ratio:

• Low asset turnover ratios might mean the company has too much capital tied up in its asset base. It also shows that it is unable to generate a high income from the given assets.
• A turnover ratio that is too high might imply that the firm has too few assets for potential sales or that the asset base is outdated.

• Working Capital Turnover Ratio

This ratio measures how well the company has used its working capital to generate sales. Working capital is needed to run day-to-day business operations and is measured by the difference between current assets and liabilities. Ideally, the company should use minimum working capital to generate maximum sales. 

Formula:

Working capital turnover ratio = Revenue / Average working capital 

Interpretation of the Ratio:

• A high working capital turnover ratio implies that the firm needs less working capital to generate a high revenue. It shows that the firm is capital-efficient. 
• Some firms may have meagre working capital if outstanding payables equal or exceed inventory and receivables. In this case, the working capital turnover ratio will be huge, vary significantly from one period to another, and will be less informative about changes in the firm’s operating efficiency.

Numerical Example 

In the above section of this chapter, we discussed various types of efficiency or turnover ratios. Applying and analysing the ratios on a company's financial statements is equally important. For this chapter, and going further, we will be calculating and analysing the financial statements of XYZ Ltd. The financial statements of XYZ Ltd were discussed in detail in the financial statement chapters. The steps you need to follow to understand this section are simple:

1. Step 1: Snapshots of the actual financial statements are provided below. These statements consist of the crucial financial statements of XYZ Ltd - statement of profit and loss, balance sheet and cash flow statement. 
2. Step 2: A table named ‘Data Extract’ is provided below the snapshot for easy understanding. This table will include all the important line items and related numerical data from the financial statements of XYZ Ltd. needed to calculate a particular category of the ratio, like efficiency ratios. Please note all the amounts are in ₹ crore.
3. Step 3: The solutions table is provided below the data extract table. This table includes the value of all the ratios taught in a particular chapter. However, you are expected to calculate the ratio value by yourself and then match your answers with the solution table to understand the concept better.
4. Step 4: The analysis and interpretation section is provided towards the end. This includes the analysis of XYZ Ltd based on ratios calculated. 

Let’s start with the exercise:

Financial statements of XYZ Ltd:

Data extract:

Extract of data needed for turnover ratios
	[Amount in ₹ crore ]	[Amount in ₹ crore ]
Particulars	March 2023	March 2022
Revenue from operations	11,529	10,888
Trade receivables	848	646
Cost of goods sold	6,267.21	5,640
Inventory	2,024	1,911
Purchases	1,052	882
Trade payables	2,186	2,017
Total assets	13,654	12,284
Total current Assets	4,248	4,316
Total current Liabilities	3,609	3,322

 

Solution:

	March 2023
Average receivables	747
Average inventory	1,967.5
Average trade payables	2,101.5
Average total assets	12,969
Average working capital	816.5
Value of turnover ratios:
Accounts receivables turnover ratio	15.43
Inventory turnover ratio	3.19
Payables turnover ratio	0.50
Total assets turnover ratio	0.89
Working capital turnover ratio	14.12

Analysis and Interpretation 

• From the above solutions table, you can see that the average collection period for XYZ Ltd. from its debtors is approximately 23 days [365 / Accounts receivables turnover ratio]. 
• The average inventory in hand is 114 days [365 / inventory turnover ratio]. 
• Meanwhile, the average number of days it takes to pay back its creditors is 730 [365 / payables turnover ratio]. 
• Thus, this shows that the company's liquidity position is strong as it can collect timely payments from its debtors and quickly sell its inventory. However, when it comes to payment to creditors, the company is using strong credit terms to pay back its creditors. Thus, it can delay its payment to creditors. This leads to lower working capital requirements for the company. 
• However, when it comes to the contribution of total assets to revenue generation, the ratio is less than 1, which is generally not considered good. The company should ensure that the assets are utilised efficiently to increase their contribution to the top line. 
• As discussed above, working capital requirements are low for the business, and therefore, the working capital turnover ratio is high, which is a positive sign.
• Thus, XYZ Ltd's efficiency position seems very strong, especially regarding liquidity. However, there are concerns regarding the efficiency of total assets. Of course, this should not be looked upon in isolation. Comparison with its historical value of ratios and peer comparison is equally important to conclude the findings. 

Where Can I Check Fundamental Ratios on Angel One?

In order to check fundamental ratios on Angel One, simply:
1. Click on the stock from the search bar or from the Watchlist.

2. Click on ‘Overview’ and thereafter, click on ‘Stock Details’.
3. Scroll down and you will find fundamental ratios.

Summary of Efficiency Ratios

These were the most common turnover ratios used to analyse the companies. But the list doesn’t end here, and there are a bunch of other turnover ratios, too. Ideally, we prefer higher values for turnover ratios, i.e., the higher the ratio, the better the firm is. But as mentioned in the individual ratios description, extreme values of any ratio should raise eyebrows for an investor, and they should dig deeper to identify the reasons for the same. 

Let’s move on to our next discussion on the ratios that measure the short-term paying capacity of the company i.e. liquidity ratios.