Fri. Aug 12th, 2022

    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.:

    PARTICULARS2020 (IN MILLION USD)2019 (IN MILLION USD)
    Net Sales39,54034,922
    Cost of Goods Sold14,05612,586
    Accounts Receivable3,8213,989
    Average Accounts Receivable(3,821+3,989)/2=3,905
    Accounts Payable869786
    Average Accounts Payable(869+786)/2=827.50
    Current Liabilities (A)13,85813,358
    Current Assets (B)35,69931,574
    Working Capital (B)-(A)35,699-13,858=21,84131,574-13,358=18,216
    Average Working Capital(21,841+18,216)/2=20,028.5
    Inventories1,2351,322
    Average Inventory(1,235+1,322)/2=1278.5
    Fixed Assets4,1513,893
    Average Fixed Assets(4,151+3,893)/2=4,022
    Total Assets58,73453,340
    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 RATIOSFORMULACALCULATIONRATIO
    Accounts Receivables TurnoverSales/Average Accounts Receivables39,540/3,90510.13
    Average No. of Days Receivables Outstanding365/Accounts Receivables Turnover365/10.1336.03 Days
    Inventory TurnoverCost of Goods Sold/Average Inventory14,056/1278.511
    Average No. of Days Inventory in Stock365/Inventory Turnover Ratio365/1133.18 Days
    Accounts Payables TurnoverTotal Purchases/Average Accounts Payables13,969/827.5016.88
    Average No. of Days Payable Outstanding365/Accounts Payables Turnover365/16.8821.62 Days
    Working Capital TurnoverSales/Average Working Capital39,540/20,028.51.97
    Fixed Asset TurnoverSales/Average Fixed Assets39,540/4,0229.83
    Total Assets TurnoverSales/Average Total Assets39,540/56,0370.71

    Sources: PinterPandai, Corporate Finance Institute