Important Efficiency Ratios


Every business has assets of some kind and for some, such as manufactures and retailers, they can represent a very large investment of cash – cash that is tied up until the finished product or item is sold. Efficiency Ratios (also sometimes referred to as ‘activity ratios’) measure how effectively your business is utilising its main assets such as inventory, accounts receivable and fixed assets. This article restricts itself to just one ratio related to each type of asset but keep in mind that your accountant can run a number of others using the figures on your financial statements. In conjunction they will give you a more rounded and insightful assessment of how effectively your business is performing.

Ratios For Inventory Analysis

How efficiently inventory is managed will have a significant impact on cash flow and, ultimately, your business' success or failure.

Inventory Turnover Ratio: shows how often a business' inventory turns over during the course of the year.

Formula: cost of goods sold / average value of inventory

Because inventory is the least liquid form of asset a high inventory turnover ratio is generally a positive - you are retrieving the dollars you have invested in inventory quickly through sales and inventory is not sitting around on the shelf. On the other hand, an unusually high ratio could mean your business is losing sales because turnover is so rapid you experience stockouts. If inventory is turning too slowly it could indicate an impending cash flow problem. The best way to assess whether your turns are too high, too low or about right is to compare it with that of other businesses in the same line of operations. Hardware stores for instance average 3.5 turns p.a. and grocery stores 12.7 on a national basis.

There are two ways to increase your Inventory Turnover Ratio, by reducing inventory level and/or increasing sales. Since reducing stock too dramatically can lead to stockouts, the call you make must be a matter of judgment. Your judgment can be improved by carrying out the analysis on each individual stock line. You might decide to not buy in any more of the slow moving items until their stock level diminishes or even discontinue stocking the item altogether.

Ratios For Receivables Analysis

Accounts receivable represent sales for which payment has not yet been collected. Depending on the extent to which you sell on credit, the payment of accounts receivable could represent your single most important source of cash inflow.

The Average Collection Period Ratio: measures the length of time it takes, on average, to convert sales into cash. A longer average collection period means a higher amount tied up in accounts receivable (customer credit) which means less cash is available to cover cash outflows such as paying bills.

Formula: current accounts receivable balance / average daily sales

A longer than industry average collection period may mean your payment terms are too lenient or that you are not doing a good enough job on collecting what’s due. Improving collection activities and tightening your credit policy will help. Though tracking and collecting overdue accounts is, for many small business owners, an unpleasant task, the speed at which bills are collected has a significant impact on cash flow.

Ratios For Fixed Asset Use

Some firms rely heavily on their fixed assets in order to carry out their business operations. For these capital intensive firms the Fixed Asset Turnover Ratio indicates how well the business is using its fixed assets to generate sales.

Formula: sales / fixed assets

Generally speaking, the higher the ratio the better because a high ratio indicates that the business has less money tied up in fixed assets for each dollar of sales revenue. Heavy spending on capital equipment to push ahead of the competition may be necessary but eventually that investment has to result in increased sales value, and an increasing ratio over time indicates that that is what is happening. A declining ratio may indicate that you've over invested in plant, equipment, or other fixed assets.

As a business owner/manager you're concerned with making the best use of your assets and keeping down production costs. You can determine how efficiently your business is utilising its assets, and where there's room for improvement, using Efficiency Ratios.

Until next week,
Mike Reddy