The Value of Efficiency Ratios

The Value of Efficiency Ratios

As a business owner it is important to understand how efficient your company is at managing assets such as inventory and receivables. This information is identified during a financial analysis exercise. Efficiency ratios vary from industry to industry, but the most common include inventory turnover, receivables turnover, fixed asset turnover, and total asset turnover. 

 

Inventory Turnover Ratio

The inventory turnover ratio is an efficiency ratio that shows how many times average inventory is “turned” or sold during a period. It is an important measure of how well a company generates sales from its inventory. Inventory includes all the goods a company has in stock, raw materials, work-in-progress materials, and finished goods. This ratio calculates as: 

Inventory Turnover = Cost of Goods Sold / Average Inventory

Inventory turnover shows how efficiently a company controls its merchandise. As a result, the higher the inventory turnover the better. This means the company is effectively and quickly selling goods and there is a demand for the product. It also shows that the company doesn’t overspend by buying too much inventory, or waste resources storing it. But, sometimes a high inventory ratio results in lost sales, as there is not enough inventory to meet the demand. 

Investors look at this ratio to see how liquid a company’s inventory is. If the inventory, can’t sale it is worthless. Creditors find interest in this ratio as inventory is often used as collateral for loans. They want to know that the inventory will be easy to sell. 

A company’s inventory turnover varies by industry. For example, fashion retailers tend to have higher turnover than car dealerships but less than grocery stores. In short, low=margin industries tend to have higher inventory turnover ratios than high-margin industries. This is due to low-margin industries offsetting lower profits with higher sales volumes. Above all, it is important to compare your company’s inventory turnover ratio to the industry benchmark to assess if you are successfully managing your inventory. 

 

Days Sales in Inventory Ratio

The days sales in inventory ratio measures how many days on average it will take a company to sell all its inventory. This figure represents how many days a company’s current stock of inventory will last. Generally, a lower ratio indicates a shorter time to exhaust the inventory. The ratio calculates:

Days Sales in Inventory = Inventory / COGS x 365

The days sales in inventory ratio indicates the efficiency of a business’s sales performance and inventory management. A low ratio is desirable since it costs money to store, insure, and finance inventory. In some industries, inventory can become obsolete over time. If a company keeps too low of an inventory balance, stock-outs can occur. As a business owner, you don’t want to risk a stock out, but you also don’t want to keep more inventory on hand than needed. A high ratio may indicate slow sales performance or excess inventory. Yet, it is possible that a company retains higher inventory levels to meet increased demand during peak seasons such as the holidays. 

This ratio is important to creditors and investors as it measures value, liquidity, and cash flows. Both want to know how valuable the inventory is. The newer the inventory the more it is worth. Shorter days inventory means the company converts its inventory into cash quicker. Thus it minimizes handling costs and increases cash flows.  

Managing inventory levels is vital for most businesses, especially retail companies or those selling physical goods. This ratio is one of the best indicators of a company’s efficiency at turning over inventory and generating sales. It also goes a step further by putting it into a daily context. This gives the owner a more accurate picture of the company’s inventory management and overall efficiency. 

The average days sales in inventory differs from one industry to another. To get an accurate comparison, one should choose companies in the same industry with similar demographics. For instance, a retail store like Target can be compared to Walmart’s inventory and sales performance. 

 

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is an efficiency ratio that measures how many times a business turns it accounts receivable into cash during a period. It shows how well a company uses and manages the credit it extends to customers and how fast short-term debt is collected or paid. It calculates as: 

Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

Net credit sales is cash collected at a later date. Calculates as sales on credit minus sales returns and allowances. Average accounts receivable is the sum of starting and ending accounts receivable in a period divided by two.

This ratio shows how efficient a company is at collecting its credit sales from customers. Some may take 90 days while others take up to 6 months. It also measures how many times a company’s receivables are converted into cash in a period. This ratio can be calculated on an annual, quarterly, or monthly basis. 

The higher this ratio the more frequent a company is collecting its receivables throughout the year. For instance, a ratio of 2 means the company collected it average receivables twice during the year or every six months. Higher efficiency increases cash flow as well. If a company collects cash sooner from customers, it is able to use it to pay bills and other obligations sooner. 

This ratio is also indicates the quality of credit sales and receivables. A higher ratio shows that a high proportion of quality customers pay off their debts quickly. Lenders often looks at accounts receivable as collateral for loans. A high receivable turnover ratio may also show a company operates on a cash basis. 

A low receivables ratio could be due to poor collection processes, bad credit policies, or financially viable customers. If this is the case a company should assess it policies to increase the timely collection of its receivables. 

 

Fixed Asset Turnover Ratio

The fixed asset turnover ratio measures operating performance. This ratio shows a company’s ability to generate sales from its fixed-asset investments. It compares net sales to net fixed assets over an annual period. Net fixed assets include property, plant, and equipment less accumulated depreciation. This ratio calculates: 

Fixed Asset Turnover = Net Sales / Average Fixed Assets

A higher fixed asset turnover ratio indicates the effective use of investments in fixed assets to generate revenue. It can also mean a company has sold off its equipment and is outsourcing its operations. Outsourcing may result in the same amount of sales, but less investment in equipment. There is not an exact number or range. So a company should compare this ratio to its own historical ratios, peer companies, or the industry average. 

This ratio is significant in certain industries. An investor or analyst determines if the subject company is in the appropriate sector or industry before giving much weight to it. This ratio is commonly used in manufacturing industries. For example, Facebook has a smaller fixed asset base than a manufacturing giant like Caterpillar. As such, Caterpillar’s fixed asset turnover ratio is more relevant and holds more weight than Facebook’s ratio. 

 

Total Asset Turnover

The total asset turnover ratio is an efficiency ratio that measures a company’s ability to generate sales from its assets. It compares net sales with average total assets. The ratio shows how many sales are generated from each dollar of company assets. It computes as:

Total Asset Turnover = Net Sales / Average Total Assets

High turnover ratios mean a company uses its assets effectively. For instance, a ratio of 1 means the company is generating one dollar of sales for every dollar invested in assets. This ratio gives investors and creditors an idea of how a company is using its assets to produce products and sales. 

Some industries use assets more efficiently than others. Businesses in the retail and consumer sector have relatively small asset bases but high sales volume – thus, high asset turnover. Conversely, firms in utilities and real estate have large asset bases and low asset turnover. 

 

Ratios in Use

Efficiency ratios by themselves do not offer much information. Once you learn about each of these ratios, you can compare them to industry averages and previous quarters and years. This provides insight and value to your analysis and understanding of business. This comparison can help you can identify trends, make changes, and bring clarity to your business operations and investments.

We at Peak Business Valuation would love to help you understand your financial analysis and how to use it to grow your business. We are happy to answer any questions you have. Please reach out via email or phone call.

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