What is Efficiency Ratio: Meaning, Types, Formula and More

An organisation may earn crores of rupees through sales but may be inefficient in its operations. But how do we know if a company is utilising its money, resources, and assets constructively? This is where the efficiency ratio becomes useful.

In the Indian business environment, competition is extremely high. From small kirana stores and family-run businesses to large corporations listed on the NSE and BSE, all of them have to ensure that they use their resources efficientlyresources efficiently. Increasing operating expenses, changes in consumer behaviour, e-commerce, and pressure on profitability further highlight the importance of efficiency.

Efficiency ratios help assess how efficiently a firm uses its assets and manages its operating costs.

In layman's terms, an efficiency ratio is an answer to one critical question: "How much business is the company generating from the resources it has?"

In this article, we will explain the meaning and importance of the efficiency ratio, types of efficiency ratios, formulas, and ways to improve them.

What is an Efficiency Ratio?

The efficiency ratio is a financial tool that helps assess how efficiently a business is using its resources to generate revenues or run its operations.

A company operates with various assets such as cash, inventory, machinery, buildings, vehicles, and others. The company uses these assets to produce products and generate revenues.

For example, a manufacturing company in Gujarat has machinery and other resources worth ₹10 crores and annual revenues amounting to ₹30 crores. In such a case, we can assess how efficiently the resources are being utilised to generate revenues.

The basic idea is straightforward:

Better use of resources generally means better efficiency. However, there is no single efficiency ratio that can provide a complete picture of a business. Different ratios focus on different areas, such as assets, inventory, receivables, and payments to suppliers.

Importance of Efficiency Ratios

Efficiency becomes particularly crucial in India's competitive corporate environment. Companies in India operate in a highly diverse set of market environments. The small retail store in New Delhi, the automobile manufacturing business in Maharashtra, and an IT services company in Bangalore operate on totally different business models. Their resource needs and financial ratios shall also differ significantly.

A business operating in India can achieve efficiency and benefit from it in many ways, such as:

• Reducing unnecessary expenses.
• Improving cash flow.
• Avoiding excess inventory.
• Collecting payments from customers faster.
• Increasing efficiency of fixed assets.
• Effective management of working capital.
• Improving return on business resources.
• Competing effectively in the market. For investors, efficiency ratios can provide useful information about how well a company's management is using its available resources.

Types of Efficiency Ratios

There are various efficiency ratios available for financial analysis. Some of the popular ratios are the asset turnover ratio, inventory turnover ratio, accounts receivable turnover ratio, and accounts payable turnover ratio. Now let us look at each ratio with some examples.

Asset Turnover Ratio

The asset turnover ratio measures how efficiently a company utilises its total assets to generate sales the efficiency of utilisation of total assets by the company to produce its sales.

Asset Turnover Ratio= Net Sales ÷ Average Total Assets

Suppose the sales figure of an Indian manufacturing company in a year is ₹50 crore. Its average total assets are ₹25 crore.

So,

Asset Turnover Ratio = ₹50 crore ÷ ₹25 crore = 2 times

It means that the company generates ₹2 in sales for every ₹1 invested in its assets.

Hence, a higher asset turnover ratio generally indicates more efficient utilisation of assets.

But this ratio should always be compared to other companies in the same industry. For example, an Indian manufacturing company will have a lower asset turnover ratio than an IT services company because of higher investment in factories and machinery.

Inventory Turnover Ratio

Inventory forms a significant portion of working capital for most Indian companies.

Imagine a supermarket, a clothes retail chain, an electronics retailer, or an auto spare parts dealer. Such businesses might have large amounts of cash invested in their stock.

The inventory turnover ratio is used to determine how quickly a business sells and replenishes its inventory.

Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory

Consider an Indian retail company that has a cost of goods sold of ₹12 crore and average inventory of ₹2 crore.

Inventory Turnover Ratio = ₹12 crore ÷ ₹2 crore = 6 times

This shows that the business turns over its average inventory about 6 times per year.

A high inventory turnover ratio indicates that products are being sold at a faster rate, while a lower ratio could mean that inventory is taking too long to sell and is remaining in warehouses or shops.

For retailers, this is particularly important because unsold fashion items, electronics, and other commodities would have lost their relevance and may need to be sold out at discounts. However, very high turnover ratios are not necessarily good, as they may indicate insufficient inventory levels, which could lead to stock shortages.

Account Receivable Turnover Ratio

Most Indian companies operate on credit terms when selling their products or services. Industries like manufacturing, wholesale, construction, and business-to-business service providers follow such practices.

If there is a sale transaction on credit, the firm will record the money owing by the customer as accounts receivable.

The accounts receivable turnover ratio evaluates how well the business collects money from customers.

The calculation is as follows:

Accounts Receivable Turnover Ratio = Net Credit Sales ÷ Average Accounts Receivable

Imagine an Indian company whose net credit sales are ₹20 crore and the average accounts receivable are ₹4 crore.

₹20 crore ÷ ₹4 crore = 5 times

Thus, the company is turning over the average receivables roughly 5 times per year.

The higher the value of this ratio, the better it is for the company as it implies quicker collection of payments from customers.

This is because a high level of sales does not necessarily mean that the firm has sufficient cash in the bank. There can be cases where the company reports good sales but faces cash flow problems due to late customer payments. For most Indian MSMEs, effective accounts receivable management is particularly crucial.

Account Payable Turnover Ratio

Accounts Payable refers to the amount a company owes to its suppliers. For instance, an Indian restaurant may purchase food products from suppliers on credit. Similarly, a manufacturing company purchases raw materials from vendors and makes payments after an agreed period. This ratio indicates how quickly a firm pays its suppliers.

A commonly used formula for calculating this is;

Accounts Payable Turnover Ratio = Net Credit Purchases ÷ Average Accounts Payable

If a company makes net credit purchases of ₹15 crore and average accounts payable of ₹3 crore.

₹15 crore ÷ ₹3 crore = 5 times

This means that the company rotates its accounts payable five times a year.

A high ratio can suggest that the firm makes quick payment to its suppliers. This is good for maintaining relationships with suppliers but may also suggest that the firm makes its payment early, thus utilising cash prematurely.

On the other hand, a low ratio conserves cash, but late payments may strain the relationship with suppliers.

Let us understand all types of Efficiency ratios with this simple example:

Assume that ABC Ltd has the following numbers:

• Sales per year: ₹100 crore
• Cost of goods sold: ₹60 crore
• Average total assets: ₹50 crore
• Average inventory: ₹10 crore
• Credit sales per year: ₹80 crore
• Average accounts receivable: ₹8 crore

Now we can work out a few efficiency ratios.

Asset Turnover: ₹100 crore ÷ ₹50 crore = 2 times

This means the company earns ₹2 for every ₹1 worth of asset it holds.

Inventory Turnover: ₹60 crore ÷ ₹10 crore = 6 times

This indicates that the company turns its average inventory 6 times in one year.

Receivables Turnover: ₹80 crore ÷ ₹8 crore = 10 times

This means the company turns its average receivables 10 times a year.

Of course, all this makes sense when the figures are compared with those from previous years and with those of other companies. For instance, if the company’s inventory turnover ratio was 8 times last year but has fallen to y 6 times this year, then there must be something wrong.

Efficiency Ratios in Banking Sector

The efficiency ratio in the banking sector typically denotes a bank’s operating expenses as a proportion of operating revenue. This can demonstrate the level at which the bank uses operating expenses to earn its revenue.

A popular formula is as follows:

Efficiency Ratio = Operating Expenses ÷ Operating Revenue × 100

Suppose there is a bank having ₹1,000 crore in operating revenue and ₹600 crore in operating expenses.

The efficiency ratio for such a bank will be calculated as:

₹600 crore ÷ ₹1,000 crore × 100 = 60%

In banking, a low efficiency ratio is preferable because it indicates that the bank incurs lower cost to generate each rupee of revenue.

This differs from some turnover ratios, where a higher number may generally indicate better efficiency. That is why it is important to understand which efficiency ratio is being used before deciding whether a higher or lower number is good.

How Indian Investors Can Use Efficiency Ratios?

Investors can use efficiency ratios when analysing companies listed on Indian stock exchanges. Let's suppose an investor is analysing two companies operating in the same industry segment. Both the companies have equal sales and profits, but one company generates those sales using significantly fewer assets. This company may be utilising its assets effectively.

Similarly, the trends could be seen by investors.

For instance, if a company has been experiencing declining inventory turnovers for several years, then investors should check whether the company is facing difficulties managing inventory.

Similarly, if the company has increasing accounts receivable relative to sales, then it needs to find out why customers are paying slowly. However, investors should never make an investment decision just based on any single ratio.

Factors That Affect Efficiency Ratios

Several factors might affect efficiency ratios.

• Industry: Efficiency ratios differ across industries. It would not be correct to compare a grocery retailer, an IT company, and a steel manufacturer.
• Size of the Business: Large businesses might enjoy economies of scale while smaller ones might have higher unit costs.
• Location: Businesses in various Indian cities and states may have different operating costs.
• Receivables Policy: Companies that give customers long credit terms will have low receivables turnover.
• Inventories: Incorrect demand forecasting can result in overstocking or understocking, which can reduce efficiency.
• Technology: The use of technologies like automation, e-payments, accounting, and inventory software improves efficiency.

FAQs

What is an efficiency ratio?

An efficiency ratio is a financial measure that shows how effectively a business uses its assets and resources to generate sales or manage its operations.

What are the main types of efficiency ratios?

The main types include the asset turnover ratio, inventory turnover ratio, accounts receivable turnover ratio, and accounts payable turnover ratio.

What is the asset turnover ratio?

The asset turnover ratio measures how efficiently a company uses its total assets to generate sales. It is calculated by dividing net sales by average total assets.

What does a high inventory turnover ratio mean?

A high inventory turnover ratio generally means that a business is selling and replacing its inventory quickly. However, an extremely high ratio may also indicate that the company is keeping insufficient stock.

Why are efficiency ratios important for Indian businesses?

Efficiency ratios help Indian businesses monitor inventory, receivables, assets, and working capital. They can also help identify areas where resources are being wasted or used inefficiently.

Is a higher efficiency ratio always better?

No. It depends on the type of efficiency ratio being used. For example, a higher turnover ratio is generally positive, while a lower banking efficiency ratio is usually considered better.

How can a business improve its efficiency ratio?

A business can improve efficiency by managing inventory better, collecting customer payments faster, reducing unnecessary expenses, improving asset utilisation and using technology to automate routine processes.

Can investors use efficiency ratios to analyse Indian companies?

Yes. Investors can use efficiency ratios along with profitability, debt, cash flow and other financial ratios to understand how effectively an Indian company is managing its resources.