# Efficiency Ratio (Activity Ratio)

Efficiency ratio, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources.

#### Efficiency Ratio Formulas

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

Measures the efficiency of extending credit and collecting the same. It indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process. A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. While a low ratio implies the company is not making the timely collection of credit.

##### Days Sales Outstanding = 360 Days ÷ Receivable Turnover

Also known as “receivable turnover in days”, “collection period”. It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.

##### Inventory Turnover = Cost of Sales ÷ Average Inventory

It represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.

##### Days Inventory Outstanding = 360 Days ÷ Inventory Turnover

Also known as “inventory turnover in days”. It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO the better.

##### Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable

Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes.

##### Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover

Also known as “accounts payable turnover in days”, “payment period”. It measures the average number of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained above).

##### Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding

Measures the number of days a company makes 1 complete operating cycle, i.e. purchase merchandise, sell them, and collect the amount due. A shorter operating cycle means that the company generates sales and collects cash faster.

##### Cash Conversion Cycle = Operating Cycle – Days Payable Outstanding

CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better.

##### Total Asset Turnover = Net Sales ÷ Average Total Assets

Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.

## Examples

FINANCIAL SUMMARY OF HELLO Ltd.

Following is the table representing the financial summary of Hello Ltd.:

 PARTICULARS 2020 (IN MILLION USD) 2019 (IN MILLION USD) Net Sales 39,540 34,922 Cost of Goods Sold 14,056 12,586 Accounts Receivable 3,821 3,989 Average Accounts Receivable (3,821+3,989)/2=3,905 Accounts Payable 869 786 Average Accounts Payable (869+786)/2=827.50 Current Liabilities (A) 13,858 13,358 Current Assets (B) 35,699 31,574 Working Capital (B)-(A) 35,699-13,858=21,841 31,574-13,358=18,216 Average Working Capital (21,841+18,216)/2=20,028.5 Inventories 1,235 1,322 Average Inventory (1,235+1,322)/2=1278.5 Fixed Assets 4,151 3,893 Average Fixed Assets (4,151+3,893)/2=4,022 Total Assets 58,734 53,340 Average Total Assets (58,734+53,340)/2=56,037

With the help of above summary, we have calculated the efficiency ratios and they are presented as below. This will give a fair idea on how to calculate the efficiency ratios.

 RATIO CALCULATION FOR THE YEAR 2020 EFFICIENCY RATIOS FORMULA CALCULATION RATIO Accounts Receivables Turnover Sales/Average Accounts Receivables 39,540/3,905 10.13 Average No. of Days Receivables Outstanding 365/Accounts Receivables Turnover 365/10.13 36.03 Days Inventory Turnover Cost of Goods Sold/Average Inventory 14,056/1278.5 11 Average No. of Days Inventory in Stock 365/Inventory Turnover Ratio 365/11 33.18 Days Accounts Payables Turnover Total Purchases/Average Accounts Payables 13,969/827.50 16.88 Average No. of Days Payable Outstanding 365/Accounts Payables Turnover 365/16.88 21.62 Days Working Capital Turnover Sales/Average Working Capital 39,540/20,028.5 1.97 Fixed Asset Turnover Sales/Average Fixed Assets 39,540/4,022 9.83 Total Assets Turnover Sales/Average Total Assets 39,540/56,037 0.71