What is Efficiency Ratio?

The efficiency ratio, also referred to as an activity ratio, is a key metric that allows companies or businesses to calculate how well they are utilising their resources and assets.

By calculating this ratio, a company determines how well it is currently or should be using capital and other sorts of assets to generate an optimised profit.

As an investor, understanding this ratio might help you determine how well a company is managing its assets and liabilities to generate profits, as that shapes your investment decision.

How is the Efficiency Ratio Calculated?

The efficiency ratio serves as a tool for comparative analysis to understand the amount of profit or revenue it might generate relative to the costs incurred for its daily operations.

As a general rule of thumb from the perspective of an investor, a good efficiency ratio of a company indicates that it has the potential to put its resources to good use. This signifies the growth potential that an investor typically seeks from an investment.

Thus, as an investor, to better understand the efficiency ratio meaning, you must have an idea of how to calculate it. Here is the efficiency ratio formula that applies:

Efficiency Ratio = Expenses from operations / Net operating income * 100

Here, the expenses of operation mean the expenses that a company has made for paying employee salaries, their benefits, equipment costs, costs for advertising or promoting businesses, etc.

The net operating income is the entire review of a company after deducting the costs of sold goods, loan loss provisions, etc.

For more clarity, assume that a company that you are looking to invest in has a net operating income of INR 50,00,000. Its operational expenses are at INR 20,00,000. Placing these into the formula, we get:

Efficiency Ratio = (INR 50,00,000 / INR 20,00,000) * 100 = 40%.

It signifies that the company spends INR 40 on its operating expenses for every INR 100 of net operating income. As an investor, a lower percentage from this ratio means the company is better in terms of efficiency, and a potential growth opportunity might be there.

Different Types of Efficiency Ratios

Like other investors, you might also be interested in different types associated with this metric when evaluating a company’s stocks. Aside from calculating an efficiency ratio, here is a detailed view of its types:

1. Inventory Turnover Ratio

Being a type of efficiency ratio, an inventory turnover ratio determines how well a business or a company is able to manage its inventory. It essentially helps estimate how many times a company is selling off its inventory and replacing it over a specified time frame.

The following is the formula that a company uses to calculate its inventory turnover:

Inventory Turnover Ratio = (COGS or Cost of Goods Sold / Average Inventory).

The COGS here represents the expenses that a company incurs to manufacture or buy goods and sell them during the specified period, typically 1 year. As the name implies, the average inventory is the amount of inventory that a company holds on average during the period.

For example, the COGS of a company for a year is INR 70,00,000. The average inventory value is at INR 20,00,000. Thus, the inventory turnover ratio here is:

Inventory Turnover Ratio = (INR 70,00,000 / INR 20,00,000) = 3.5.

2. Asset Turnover Ratio

Being a type of efficiency ratio, the asset turnover ratio measures the capability of a company to efficiently use its assets to generate optimised profits. Here, you divide the net sale of a company or a business by its average total assets. The following is its formula:

Asset Turnover Ratio = Net company sales / Average total assets

As the name implies, the net sales here mean the net revenue a company has generated over a specified time. The average total asset is the total underlying asset the company had over that same timeframe.

Suppose a company has generated INR 30 lakh in revenue in a year. The worth of its assets was 15 lakh. Now, let us place these in the above formula:

Asset Turnover Ratio = 30 lakh / 15 lakh = 2.

It means that the company in the last 1 year was able to generate INR 2 in net sales for each INR 1 in terms of average total assets. As an investor, this score is important for you. It is because while comparing other companies for a stock investment, the higher the score is, the more it implies the company is potentially more efficient in leveraging its assets to generate profit.

3. Operating Ratio

This type of efficiency ratio acts as a profitability measure evaluating the operating expenses in relation to the total revenue or net sales.

Before investing and while doing company research as an investor, it gives you an idea of how your chosen company is efficiently generating profits from its operations. The following is the applicable formula for this ratio:

Operating Ratio =  (Operating expenses / Net revenue from sales) * 100

Suppose the net revenue your company generates from sales is INR 20,00,000. Its operating expense for that stands at INR 4,00,000, which makes the ratio:

Operating Ratio = (INR 4,00,000 / 20,00,000) = 20%.

Comparing this ratio with other companies before investing gives you a clear picture of its efficiency. A lower score here represents that a company is expending a lesser amount on operations per rupee of sales revenue.

4. Accounts Receivable Turnover Ratio

This type of efficiency ratio measures how potentially efficient a company is in terms of collecting payments from its customers over a specified period. To arrive at it, you must use the following formula:

Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

Here, the net credit sales mean the total revenue a company has generated from sales on credit. It excludes allowances, returns, and discounts that the company offered during the sales.

An average accounts receivable is the amount the company owes from its customers over the same specified time. You calculate it by adding the opening accounts receivable to the closing accounts receivable statement by 2.

Suppose the company you are tracking to invest in has a net credit sale of INR 20,00,000 per year. Its opening account receivable is INR 3,00,000, and its closing account receivable is INR 3,50,000. It yields an average accounts receivable of INR 3,25,000.

Here the Accounts Receivable Turnover = (20,00,000 / 3,25,000) =             6.15

It means that this company collects its average receivables about 6.15 times in that year.

As an investor, you must monitor a company’s average receivable turnover before investing, as a higher score is considered good. In contrast, a lower score indicates lower efficiency in collecting payments, or it might have a poor credit policy.

Factors Which Affect Efficiency Ratio

Now that you have an idea of what the efficiency ratio is in a company and its calculation process, you must have a look at some underlying factors that impact it:

1. Efficiency of the Management

With a good efficiency ratio comes the importance of the leadership of a company. Effective leadership that makes strategic business decisions might enhance its overall efficiency, which results in a better efficiency ratio.    

2. Operational Efficiency

To achieve a good efficiency ratio, the operations of a business or a company must be optimised for efficiency as well. A well-optimised or streamlined operational process generally helps companies to reduce operating costs and generate an optimised profit.

3. Economic Conditions

Although it is a fundamental factor, it is crucial for increasing the ratio of a business or a company. A strong economy helps with cost optimisation and might result in increased sales. While a bad condition might result in the opposite, which in turn impacts investors’ return on investments.

4. Other Factors

Other factors include technological advancement, the prevailing competition in the market, industry standards, operational scales, etc. These factors also contribute to deciding good or bad efficiency ratios that you, as an investor, must look into while investing.

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What is the Importance of the Efficiency Ratio?

Efficiency ratios determine the ability of a company to optimise its asset usage and generate profits. It, in turn, helps you as an investor in the following ways:

1. Measurement of Company Performance

The efficiency ratio shows how effectively a company manages its assets and operations for profits. For example, an efficiency ratio of 40% means it spent INR 40 for operating expenses for every INR 100 of net operating income. Comparing it with an efficiency ratio of 60% means that the company has spent more for each operating income, and it is less efficient.

2. Investor Confidence

With a transparent and good ratio for efficiency of a company, an investor generally gets confidence in the competency of the company’s management. It also drives your investment decision.

3. Helps With Benchmarking

You can also use the efficiency ratio of a company as a comparative analysis tool. Use it against the industry benchmark. For example, you see a company has a ratio of efficiency of 35%. While most competitors operate in the range of 45% and 50%. It means the company is currently managing its operational costs more efficiently compared to its industry average.

Limitations of the Efficiency Ratio

Aside from being an indicator for efficiency, it also has a few limitations that you must note:

1. Limited by sector

As companies or businesses from different sectors vary in terms of operational costs and other factors, the respective efficiency ratios also vary. Hence, measuring company efficiency using it, especially for a cross-industry comparison, might not be that effective.

2. Short-Term Market Fluctuations

Short-term market fluctuation or volatility might skew the interpretation of an efficiency ratio. Hence, you must assess a company’s performance based on information from multiple periods instead of a single time frame.

Conclusion

The efficiency ratio of a company portrays how well a company or a business is using its resources, assets, etc, to generate profits. As an investor, investing in a company with a lower ratio might be effective as a lower score typically indicates the ability of a company to be more efficient, which shows growth potential.

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FAQ’s on Efficiency Ratio

1. How can companies improve their efficiency ratio?

Companies can focus on optimising their operations, reducing manufacturing or production costs wisely and employing strategic decision-making to increase the ratio.

2. How often should businesses calculate their efficiency ratio?

To monitor company performance, a business or a company must calculate this ratio quarterly or annually.

3. What factors can affect the efficiency ratio?

Factors like management and operational practices, technological improvements, economic conditions, market competition, etc, impact the ratio for efficiency.

4. Does an efficiency ratio reflect profitability?

No, it simply measures the overall performance of a business or a company. Profitability ratio generally reflects profits.