Efficiency Ratios Explained: 6 Types of Efficiency Ratios

An efficiency ratio analysis measures a company's short-term ability to turn current assets into income. Assets show up on a company’s balance sheet and can include things like cash on hand, real estate holdings, current inventory, intellectual property, and machinery. A company’s income and expenditures are reported on various financial statements—primarily income statements.

In the world of corporate finance, there are multiple ratios that measure the operational efficiency of a business or financial institution. All of these financial ratios offer a window into the management and monetary health of a company.

There are six main types of efficiency ratios that frequently come up in the world of corporate finance.

1. 1. Total asset turnover ratio: This is a profitability ratio that measures how many dollars in sales can be generated by one dollar in assets. A company's assets will vary based on the nature of its business. Property managers, for example, rely on fixed assets like real estate, while publishers may rely more on intellectual property assets to generate revenue. A high asset turnover ratio indicates the company is efficient at producing sales from assets, while a comparatively low ratio indicates the opposite. Asset turnover ratio = net sales / average total assets.
2. 2. Accounts receivable ratio: This ratio compares net credit sales (sales predicated on the money being collected later) to the average balance in a company's accounts receivable department. It measures the effectiveness of revenue collection, which impacts overall cash flow and the smoothness of operations. A high ratio indicates efficient revenue collection, while a low ratio indicates the opposite. Accounts receivable turnover ratio = net credit sales / average accounts receivable.
3. 3. Accounts payable ratio: Accounts payable (AP) is the total amount of money a company owes to vendors for supplies or services provided to run their business. The accounts payable ratio compares net credit purchases (where the company will pay others at a later date) to the average accounts payable balance. This is effectively a measure of short-term company liquidity. In this case, a higher efficiency ratio means the company regularly pays off its creditors and thus has a reasonable working capital gap. A lower efficiency ratio means that the company may be struggling to pay off creditors and could end up imperiled by high interest rates. Accounts payable turnover ratio = net credit purchases / average accounts payable.
4. 4. Inventory turnover ratio: The inventory turnover ratio is a metric that compares the cost of goods sold to the average value of inventory within an accounting period. This ratio essentially measures the number of times in an accounting period that a business sells its entire inventory. Inventory turnover ratio = cost of goods sold / average inventory value.
5. 5. Days sales in inventory ratio: Days sales in inventory (DSI), also known as the average age of inventory ratio, is a metric that estimates how long a business's current stock of inventory will last. Companies often strive for a low DSI ratio as it means they can rapidly sell their products. However, too low a DSI ratio can indicate supply chain problems and an inability to fulfill orders. Days' sales in inventory ratio = (ending inventory / cost of goods sold) x 365.
6. 6. Bank efficiency ratio: Financial institutions like banks and credit unions measure their profitability and liquidity by comparing operating expenses to their net revenues. In this context, the lower the ratio, the more efficient the bank or financial institution is at generating revenue. Bank efficiency ratio = operating expenses / net revenues.

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