Efficiency Ratio Explained: Calculation, Types, Examples, How to Improve?
Companies worldwide use various financial metrics and quantifiable measures to gain valuable insights into the effectiveness of production and sales processes. Efficiency Ratio is one such important measure that indicates a company's ability to transform resources into revenue. This blog will discuss efficiency ratios, how they are calculated, their types, and how to achieve a better efficiency ratio.
Table of Content
- What is the Efficiency Ratio?
- Example - Efficiency Ratio Comparison
- How to Interpret the Efficiency Ratio?
- Types of Efficiency Ratios
- Factors Affecting Efficiency Ratio
- Improving Efficiency Ratio
What is the Efficiency Ratio?
Efficiency ratios are financial metrics that measure how efficiently a company uses its resources to generate revenue and profits. They reflect a company's ability to control its expenses and generate more output from its inputs.
Efficiency Ratio Formula = Total Expenses ÷ Total Revenue
Where -
Operating Expenses = Costs associated with running the day-to-day operations of a business, such as salaries, rent, utilities, and marketing expenses.
Total Revenue = The total income a business generates from its core business activities, such as sales, fees, and commissions.
Read Later
Best-suited Banking, Finance & Insurance courses for you
Learn Banking, Finance & Insurance with these high-rated online courses
Example - Efficiency Ratio Comparison: Bank A vs. Bank B
Let's consider two banks, Bank A and Bank B, and compare their efficiency ratios:
- Bank A: Efficiency Ratio = 55%
- Bank B: Efficiency Ratio = 62%
In the given example, Bank A has an efficiency ratio of 55%. On the other hand, Bank B has an efficiency ratio of 62%, indicating that Bank A manages its expenses more efficiently than Bank B.
In other words, for every rupee of revenue generated, Bank A spends 55 paise on operating expenses, while Bank B spends 62 paise.
This difference in efficiency ratios can significantly impact a bank's profitability.
For example, if Bank A generates Rs. 100 million in revenue, it would spend Rs. 55 million on operating expenses, leaving a profit of Rs. 45 million. On the other hand, if Bank B generates the same Rs. 100 million in revenue, it would spend Rs. 62 million on operating expenses, leaving a profit of only Rs. 38 million.
However, it's important to note that efficiency ratios can vary across industries and different economic conditions. A low-efficiency ratio in one industry may not necessarily be good in another.
Let us now take a look at the factors affecting the efficiency ratio.
How to Interpret the Efficiency Ratio?
The efficiency ratio is valuable for assessing a company's financial and operational health. It provides a clear picture of how effectively a company manages its expenses in relation to its revenue. By analysing and comparing the efficiency ratio, stakeholders, including investors, analysts, and company management, can make informed decisions and gain insights into various aspects of the company's financial performance.
Types of Efficiency Ratios
| Efficiency Ratio |
Description |
Formula |
| Measures how quickly a company sells its inventory. A high inventory turnover ratio indicates that the company is efficient at managing its inventory and not tying up too much capital in stock. |
Cost of goods sold ÷ Average inventory value |
|
| Accounts Receivable Turnover Ratio |
Measures how quickly a company collects cash from its customers. A high accounts receivable turnover ratio indicates that the company efficiently collects its debts. |
Net sales ÷ Average total assets |
| Accounts Payable Turnover Ratio |
It measures how many times a company can pay its creditors. A high accounts payable turnover ratio typically indicates that a company pays its suppliers efficiently. |
Net credit sales ÷ Average accounts receivable |
| Asset Turnover Ratio |
Calculates how efficiently a company uses its assets to generate revenue. A high asset turnover ratio indicates that the company generates much revenue from its assets. |
Net credit purchases ÷ Average accounts payable |
| Day's Sale in Inventory (DSO) |
DSO is similar to the accounts receivable turnover ratio but is expressed in the days it takes a company to collect its receivables. A low DSO indicates that the company is efficient at collecting its debts. |
(Ending inventory/Cost of goods sold) x 365 |
Factors Affecting Efficiency Ratio
Several factors can influence a company's efficiency ratio, including:
- Industry: Different industries have varying operating costs and revenue streams, leading to different benchmark efficiency ratios.
- Company Size: Larger companies may have economies of scale, allowing them to achieve lower efficiency ratios.
- Cost Structure: Companies with higher fixed costs, such as real estate or equipment leases, can lead to higher efficiency ratios.
- Management Practices: Efficient management of expenses and resources can contribute to lower efficiency ratios.
- Geographic Location: Companies operating in regions with higher labour or regulatory compliance expenses may have higher efficiency ratios.
- For example - Companies in the United States often face higher labour costs due to minimum wage laws and occupational safety regulations; many brands like Mark & Spencer have moved to Bangladesh, which has become a central hub for clothing manufacturing due to its low labour costs. This way, the company can cut manufacturing costs and achieve low efficiency ratios.
- Economic Conditions: Economic downturns or periods of high inflation can impact a company's revenue generation and expense management, affecting the efficiency ratio.
- Business Strategy: Companies focused on growth or expansion may incur higher expenses, leading to a higher efficiency ratio than companies with a more cost-controlled approach.
- Product Mix: Companies selling high-margin products may have lower efficiency ratios than those selling low-margin products.
- Competition: In industries with intense competition, companies may face pressure to reduce prices, impacting their revenue and the efficiency ratio.
- Government Policies: Regulatory changes or tax policies can influence a company's cost structure and impact the efficiency ratio.
Improving Efficiency Ratio
Companies can implement the below strategies to improve their efficiency ratio:
Reduce Expenses
- Identify areas of excessive spending and implement cost-cutting measures.
- Negotiate better terms and prices with vendors and contractors.
- Streamline processes and workflows to reduce labour costs.
Invest in Modern Technologies
- Automate repetitive tasks by implementing new technological solutions, thereby increasing productivity.
- Use data science and analytics to identify areas where technology can improve efficiency, such as customer service or supply chain.
Improve Asset Utilization
- Optimise using physical assets such as real estate, equipment, and vehicles to minimise idle time and maintenance costs.
- Consider sharing resources or using them for multiple purposes to maximise their value.
- Train employees to be more multitasking.
- Consider outsourcing non-core functions to reduce labour costs.
Improve Existing Processes
- Continuously evaluate and improve internal processes to reduce inefficiencies.
- Encourage a culture of innovation and encourage employees to suggest improvements.
- Implement Lean or Six Sigma methodologies to identify and eliminate process waste.
Strategic Planning
- Develop a clear strategic plan that outlines specific efficiency goals and targets.
- Regularly review progress against these goals and make adjustments as needed.
Conclusion
Efficiency ratios are essential for businesses as they can help to identify areas where costs can be reduced, and productivity can be improved. Additionally, they can benchmark a company's performance against its peers or historical performance.
FAQs - Efficiency Ratios
How is the efficiency ratio calculated?
The efficiency ratio is calculated by dividing operating expenses by total revenue. Operating expenses include the costs associated with a company's day-to-day operations, such as employee salaries, rent, utilities, marketing, and other overhead costs. Total revenue is the company's total income from its core business activities.
What does the efficiency ratio tell you?
The efficiency ratio tells you how much of a company's revenue is used to cover its operating expenses. A lower efficiency ratio indicates that a company uses its resources more effectively and generates more profit from its sales. A higher efficiency ratio suggests that a company spends too much money on its operations and may not generate enough profit.
How is the efficiency ratio used?
Investors and analysts use the efficiency ratio to evaluate a company's financial health and operational efficiency. Companies also use it to track their performance and identify areas to improve their efficiency.
What are some of the limitations of the efficiency ratio?
The efficiency ratio can be affected by several factors, including the type of business, the company's industry, and economic conditions. This can make it difficult to compare efficiency ratios across different companies. Additionally, the efficiency ratio does not consider other factors affecting a company's financial health, such as its capital structure and debt levels.
Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio
Top Picks & New Arrivals
