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Ratio Analysis: Guide to Efficiency Ratios Analysis

Created on 29 May 2020

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Updated on 27 Aug 2020

Stock investing involves a careful analysis of the companies and their financial data to arrive at their true worth. One can examine the company’s Quarterly and Annual accounts to determine how productively they are managing its assets and liabilities to maximize profits. However, this can be cumbersome and will not determine the efficiency levels of the business. An easier way to find out about a company's performance is to look at its financial ratios. Though this is not a foolproof method, it is a good way to run a fast check on a company's health. Read the guide on Ratio analysis

Efficiency Ratios are a measure of how well an organization is managing its routine affairs. These ratios analysis how well a company utilizes its assets and manages its liabilities.

Let’s read on further to understand these ratios to get some clarity

  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 flows and 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 indicates the company is having difficulty in collecting its dues or being too liberal in granting credit 

       2. Account Payable Turnover/ Creditors Turnover: -

Accounts payable is short-term debt that a company owes to its suppliers and creditors. Though accounts payable are liabilities, their trend is important as they represent an important source of finance for operating activities, thereby affecting operating efficiency. 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 matrix shows 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:

A higher ratio indicates the company’s ability to keep cash on hand for a longer time, and preferable. It may also indicate that the firm is not getting favorable credit terms from its suppliers. However, a very high ratio also tells that the company is facing a liquidity crunch.

  1. 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. A lower inventory turnover ratio is an indicator that a company is not managing its inventory well. It either may be overstocking or having an issue with sales. 

  1. Fixed Asset Turnover Ratio: -

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

Formula: - Net Sales / Average Fixed Assets

Interpretation:

Interpreting the fixed asset turnover ratio is not easy. This is due to the fact that this ratio is affected by several circumstances such as the life cycle of a company, life cycle of a product, plant capacity & relative sales. Also, there are factors such as asset valuation, the timing of a firm's asset purchase that affects this ratio. Thus all else equal, A high ratio indicates a high degree of efficiency in fixed asset utilization and vice-versa.

  1. Total Asset Turnover Ratio: -

This ratio analysis provides an indication of how efficiently 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 in asset utilization and vice-versa.

Final Thoughts

Efficiency Ratios are vital for a company’s management in evaluating the operations of the business. For an investor, it is crucial for investment decisions. They are incorporated as financial analysis carried out by the investor to decide whether they represent a good investment or a creditworthy borrower. It not only helps in knowing how the company has been performing but also can be used as a comparison of companies in the same industry and zero in on the best investment option. Hope you like this article on Ratio analysis.

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Bernadine

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An MBA Finance graduate, having worked in the Telecom and Banking sector as a Risk and Compliance Manager. An avid blogger with a penchant for traveling

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