Efficiency Ratios Analysis

As an investor, you need to determine how productively your company is managing its assets and liabilities to maximize profits.Revenue turnover, profits or assets; all these figures may tell you, how big an enterprice is . However, these figures cannot give you an idea whether the business is efficient or not.

You can use efficiency ratios to assess how effectively the investments in the company are being used to generate wealth for its shareholders.A highly efficient organization need minimum investment in assets,so requires less capital and debt in order to run its business operation.

1.  Receivable Turnover/ Debtors Turnover: -

Receivable Turnover ratio is used to see the company’s efficiency in collecting its receivables or the money owed by clients. It represents sales for which payment has not been collected yet. If business normally extends credit to customers, the payment of accounts receivable is likely to be the most important source of cash flowsand is also called a Debtors Turnover ratio.

Formula: - Net Credit sales / Average accounts receivables

Interpretation:

A high ratio is always desirable as it shows the company’s efficiency in collecting the dues from clients.A low ratio indicate the company is being too liberalin granting credit .

Example: -

Net Credit Sales – 8,00,000

Beginning of the year – 10,000

End of the year – 20,000

Accounts Receivable Turnover = 8,00,000 / ((10,000 + 20,000)/2) =  53.33 times

2. Account Payable Turnover/ Creditors Turnover: -

Accounts payable is short-term debt that a company owes to its suppliers and creditors. The accounts payable turnover ratio is used to see how efficiently a company is at paying its suppliers and short-term debts.In other words, the matrixshows the speed at which a company pays its suppliers. It establishes a relationship between net credit annual purchases and average accounts payables.

Formula: - Net Credit purchases / Average accounts payables

Interpretation:

Higher ratio indicates company’s ability to  keep cash on hand for a longer time, and preferable. However, a very high ratio also tells that company is facing liquidity crunch.

3. Inventory Turnover Ratio: -

Inventory turnover ratio explains how many times a company has sold and replaced inventory during a given period. It also expresses the relationship between the cost of goods sold and inventory, and this denotes efficiency in inventory management.

Formula: - Cost of goods sold / Average inventory

Interpretation:

Higher the ratio shows better efficiency in clearing  inventories.

Example: -

Company is A has Rs. 1,00,000in cost of goods sold and inventory in beginning of the year is Rs. 30,000 and end of the year is Rs. 20,000

Inventory turnover ratio = 1,00,000/((30,000+20,000)/2) = 4 times a year

4. Fixed Asset Turnover Ratio: -

Fixed Asset Turnover tells how much amount, a company needs to investto generate 1 rupee of sales. It tells the efficiency, withwhich the fixed assets are employed. In general, it is used by analysts to measure operating performance.

Formula: - Net Sales / Average Fixed Assets

Interpretation:

• A high ratio indicates a high degree of efficiency in fixed asset utilization and vice-versa.

Example: -

Company is A has Rs. 1,00,000 in sold and fixed assets in beginning of the year is Rs. 40,000 and end of the year is Rs. 60,000 

Fixed Asset Turnover = 1,00,000/((40,000+60,000)/2) = 2 times per year

5. Total Asset Turnover Ratio: -

It says how effectively management is using both short-term and long-term assets.The higher the asset turnover ratio, the better the company is performing, since higher ratios imply that the company is generating more revenue per rupee of assets.

Formula: - Net Sales / Average Total Assets

Interpretation:

• A high ratio indicates a high degree of efficiency inasset utilization and vice-versa.

Example: -

Company is A has Rs. 4,80,000 in sold and total asset in beginning of the year is Rs. 2,00,000 and end of the year is Rs. 3,60,000 

Total Asset Turnover Ratio = 4,80,000/((2,00,000+3,60,000)/2) = 0.85 times