In my last blog, I shared an in-depth analysis on liquidity ratio as a means of evaluating a company’s debt repayment capacity.
Today I will share my understanding of Efficiency Ratio which is another type of ratio used in evaluating how well a company is sweating its asset to generate income.
The efficiency ratio measures a company’s ability to use/sweat its assets and manage its liabilities effectively.
Examples of Efficiency ratios include:
- Inventory turnover ratio
- Asset turnover ratio
- Receivables turnover ratio
These ratios measure how well the companies utilised their assets in generating revenue and its ability to manage those assets efficiently. Like any other financial ratio, in order to obtain a true analysis, it’s best to compare a company’s ratio to its competitors in the same industry.
I will share more insights into the three types of efficiency ratios and why they are important in company analysis.
- It measures how well a company is utilizing its assets in generating revenue.
- Inventory turnover ratio is used in analyzing the level and activities of sales.
- When a company has a high asset turnover, it means they are managing thier assets efficiently, while low turnover means assets are being underutilized.
- The receivables turnover ratio simply measures a company’s efficiensy in debt recovery.
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 a period. Financial analysts use the ratio to determine if there are enough sales being generated and it 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.
Let’s take for example, Company X sold goods and reported sales of N10 million. The average inventory of Company X is
N20million. The inventory turnover ratio for company X is 0.50 (N10 million/N20 million). This shows that company X is not managing its inventory well because it only sold half of its inventory for the period.
Asset Turnover Ratio:
The asset turnover ratio measures a company’s ability to efficiently generate income from its assets. In other words, the asset turnover ratio calculates revenue as a percentage of the company’s total assets. The ratio is effective in showing how many sales/revenue are generated from each naira of assets a company owns.
A higher asset turnover ratio means the company is using its assets more efficiently, while a lower ratio means the company isn’t using its assets efficiently.
The ratio is calculated by dividing a company’s sales by its total assets. For example, Company X has total assets of
N2,000,000 and sales or revenue of N1,000,000 for the period. The asset turnover ratio would equal 0.50, ( N1,000,000/ N2,000,000). In other words, the company generated N50 for every naira in assets.
Receivables turnover ratio:
The receivables turnover ratio measures how efficiently a company can actively recover its debts and extend its credits to customers. The ratio is calculated by dividing a company’s net credit sales by its average accounts receivable.
For example, Company X has an average accounts receivable of
N300,000, 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 N900,000, so the receivable turnover ratio would equal 3, meaning the company collected its receivables three times for that period.
In my next blog, I will share more insight into another type of ratio being considered in analyzing a company for investment consideration – “The profitability ratio” This ratio basically measures how well a company has improved its shareholders wealth in terms of returns on equity and net income margin.