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What Do Efficiency Ratios Measure

Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively in the short term. There are several key efficiency ratios including the inventory turnover ratio, asset turnover ratio, and receivables turnover ratio. These ratios measure how efficiently a company uses its assets to generate revenue and manage those assets by comparing things like cost of goods sold to average inventory, revenue to total assets, and net credit sales to average accounts receivable. Analysts use efficiency ratios to evaluate how well a company is managing its resources.

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46 views2 pages

What Do Efficiency Ratios Measure

Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively in the short term. There are several key efficiency ratios including the inventory turnover ratio, asset turnover ratio, and receivables turnover ratio. These ratios measure how efficiently a company uses its assets to generate revenue and manage those assets by comparing things like cost of goods sold to average inventory, revenue to total assets, and net credit sales to average accounts receivable. Analysts use efficiency ratios to evaluate how well a company is managing its resources.

Uploaded by

Darlene Sarcino
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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What Do Efficiency Ratios Measure?

Efficiency ratios measure a company's ability to use its assets and manage its
liabilities effectively in the current period or in the short-term. Although there are
several efficiency ratios, they are similar in that they measure the time it takes to
generate cash or income from a client or by 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.

Inventory Turnover Ratio


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 the cost of goods sold by the average
inventory.

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

Asset Turnover Ratio


The asset turnover ratio measures a company's ability to efficiently generate
revenues from its assets. 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 a company owns.

A higher asset turnover ratio means the company's management is using its
assets more efficiently, while a lower ratio means 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 has total assets of $1,000,000 and sales or
revenue of $300,000 for the period. The asset turnover ratio would equal 0.30,
($300,000/$1,000,000). In other words, the company generated 30 cents for
every dollar in assets.

Receivables Turnover Ratio


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 its 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.

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