Efficiency ratios measure the ability of a business to use its assets and liabilities to generate sales. A highly efficient organization has minimized its net investment in assets, and so requires less capital and debt in order to remain in operation. In the case of assets, efficiency ratios compare an aggregated set of assets to sales or the cost of goods sold. In the case of liabilities, the main efficiency ratio compares payables to total purchases from suppliers. To judge performance, these ratios are typically compared to the results of other companies in the same industry. The following are considered to be efficiency ratios:
Accounts Receivable Turnover
Accounts receivable turnover is calculated as credit sales divided by average accounts receivable. A high turnover rate can be achieved by being selective about only dealing with high-grade customers, as well as by limiting the amount of credit granted and engaging in aggressive collection activities. Conversely, a company might elect to have low receivables turnover as a result of a strategy to sell to lower-quality customers to which competitors refuse to sell.
Inventory Turnover
Inventory turnover is calculated as the cost of goods sold divided by average inventory. A high turnover rate can be achieved by minimizing inventory levels, using a just-in-time production system, and using common parts for all products manufactured, among other methods. However, it is possible to shrink inventory levels too much, if doing so results in longer delivery times to customers. It is also necessary to maintain work-in-process in front of bottleneck operations, to ensure that they never run out of work.
Fixed Asset Turnover
Fixed asset turnover is calculated as sales divided by average fixed assets. A high turnover ratio can be achieved by outsourcing the more asset-intensive production to suppliers, maintaining high equipment utilization levels, and avoiding investments in excessively expensive equipment. This turnover level varies substantially, depending on the nature of the business and the level of investment it requires.
Accounts Payable Turnover
Accounts payable turnover is calculated as total purchases from suppliers divided by average payables. Changes to this ratio are limited by the underlying payment terms agreed to with suppliers. Thus, if a supplier demands short payment terms and that is the only available supplier for a key part, then there is little management can do to improve on this ratio.
Understanding Efficiency Ratios
Efficiency ratios are used to judge the management of a business. If an asset-related ratio is high, this implies that the management team is effective in using the minimum amount of assets in relation to a given amount of sales. Conversely, a low liability-related ratio implies management effectiveness, since payables are being stretched.
Problems with Efficiency Ratios
The use of efficiency ratios can have negative effects on a business. For example, a low rate of liability turnover could be related to deliberate payment delays past terms, which could result in a company being denied further credit by its suppliers. Also, the desire to achieve a high asset ratio could drive management to cut back on necessary investments in fixed assets, or to stock finished goods in such low volumes that deliveries to customers are delayed. Thus, undue attention to efficiency ratios may not be in the long-term interests of a business.
Activity Ratios, or asset utilization ratios, are measures of a company’s operating efficiency, specifically with regard to managing its assets.
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How to Calculate Activity Ratios
The efficiency at which a company utilizes its assets can be measured by activity ratios.
An activity ratio is an indicator of how efficient a company is at asset allocation, with the goal of deriving as much revenue as possible with the least amount of resources.
One can gauge a company’s ability to manage its current assets such as inventory and accounts receivable as well as fixed assets (PP&E) to generate more revenue.
Therefore, by comparing the two sides — revenue and an asset metric — each “turnover” ratio measures the relationship between the two and how they trend over time.
Activity Ratio Formula
Each activity ratio consists of revenue in the numerator and then a measure of an asset(s) in the denominator.
Formulas
- Total Asset Turnover Ratio = Revenue / Average Total Assets
- Fixed Asset Turnover Ratio = Revenue / Average Fixed Assets
- Working Capital Turnover Ratio = Revenue / Average Working Capital
Inventory, Receivables and Payables Turnover Ratio
As a general rule of thumb, the higher the turnover ratio, the better — since it implies the company can generate more revenue with fewer assets.
The majority of companies closely track their accounts receivable (A/R) and inventory trends; hence, these accounts are frequently used in the denominator of activity ratios.
While there are numerous variations of activity ratios such as the accounts receivable turnover ratio and inventory turnover ratio, the shared purpose of each ratio is to determine how well a company can utilize its operating assets.
An improvement in activity ratios tends to correspond with higher profit margins, since more value is extracted from each asset.
Some of the more common ratios are:
- Inventory Turnover — The number of times a company’s inventory is replenished in a specific period
- Receivables Turnover Ratio — The number of times a typical customer that originally paid on credit (i.e. accounts receivable, or “A/R”) makes a cash payment in a specific period
- Payables Turnover Ratio — The number of times a company pays off its due payments to suppliers/vendors (i.e. accounts payable, or “A/P”) in a specific period
Activity Ratios Formula List
- Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory
- Receivables Turnover = Revenue / Average Accounts Receivable (A/R)
- Payables Turnover Ratio = Total Credit Purchases / Average Accounts Payable
Activity Ratios vs. Profitability Ratios
Both activity ratios and profitability ratios should be analyzed to determine a company’s financial health.
- Profitability Ratios: Profitability ratios such as the gross margin and operating margin help depict a company’s overall ability to convert revenue into earnings after accounting for different costs/expenses.
- Activity Ratios: In comparison, activity ratios measure a company’s ability to efficiently use its resources (i.e. assets) to generate profits, just on a more granular level (i.e. per asset).
Activity Ratio Calculator – Excel Model Template
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Activity Ratios Calculation Example
Here in our illustrative example, we’ll be projecting three activity ratios — the total asset turnover, fixed asset turnover, and working capital turnover ratios — across five years.
As of Year 0, the financial assumptions to be used are shown below, with the year-over-year (YoY) growth assumptions to the right.
- Revenue = $100m with +$20m Increase Per Year
- Cash & Equivalents = $25m with +$5m Increase Per Year
- Accounts Receivable = $45m with -$2m Decrease Per Year
- Inventory = $60m with -$2m Decrease Per Year
- Property, Plant & Equipment (PP&E) = $225m with -$5m Decrease Per Year
- Accounts Payable (A/P) = $50m with +$5m Increase Per Year
- Accrued Expenses = $10m with +$1m Increase Per Year
Using the assumptions provided, we can first calculate the total asset turnover ratio in Year 1 by dividing the current revenue by the average between the current and prior period total asset balance.
In the subsequent steps, we can repeat the process for the fixed asset turnover and the working capital turnover — with the denominator as the only changing variable.
Starting from Year 0 to the end of the forecast period in Year 5, the following changes occur:
- Total Asset Turnover Ratio: 0.3x → 0.6x
- Fixed Asset Turnover Ratio: 0.5x → 1.0x
- Working Capital Turnover Ratio: 1.8x → 4.2x
Interpreting the changes is predicated on the industry that our company operates in, as well as other company-specific factors that are beyond the scope of our simple modeling exercise.
However, based on the limited information available, our company’s “top line” revenue is growing by $20m each year while its cash balance is increasing by $5m.
Furthermore, A/R and inventory — metrics that measure the amount of cash tied up in operations — are declining each year, which implies the company is collecting cash payments from customers that paid on credit and clearing out inventory faster.
On the other side of the balance sheet, the increasing accounts payable balance can be perceived as a positive trend signifying increased negotiating leverage over suppliers (i.e. suppliers allowing for days payable outstanding to extend).