Efficiency ratios measure a company’s ability to use its assets and manage its liabilities effectively. Some efficiency ratios include the inventory turnover ratio, asset turnover ratio and receivables turnover ratio. These ratios measure how efficiently a company uses its assets to generate revenues and its ability to manage those assets.
The inventory turnover ratio measures a company’s ability to manage its inventory efficiently. The ratio is calculated by dividing its cost of goods sold by its average inventory. For example, suppose company ABC sells computers and reported cost of goods sold (COGS) at $5 million. The average inventory of ABC is $20 million. The inventory turnover ratio for ABC is 0.25 ($5 million/$20 million). This indicates that company ABC is not managing its inventory properly, because it only sold a quarter of its inventory for the year.
The asset turnover ratio measures a company’s ability to generate revenues from its assets efficiently. The ratio is calculated by dividing a company’s revenues by its total assets. For example, suppose a company has an asset turnover ratio of 5. Each dollar of the company’s assets generates $5 of revenue. This indicates that the company is efficient when using its assets to generate sales.
The receivables turnover ratio measures how efficiently a company can actively collect its debts and extend its credits. The ratio is calculated by dividing a company’s net credit sales by its average accounts receivable. Generally, a company with a higher accounts receivables turnover ratio, relative to its peers, is favorable. A higher receivables turnover ratio indicates the company is more efficient than its competitors when collecting accounts receivable, or it operates on a cash basis.