How to Calculate Efficiency Ratio (with Example)

Efficiency ratios are a set of financial metrics used to evaluate how effectively a company utilizes its assets and liabilities to generate revenue and maximize profitability. They are essential tools for investors, creditors, and financial analysts because they provide insight into the operational performance of a business and how well it is managing its resources. Unlike profitability ratios, which focus on measuring income and profitability, efficiency ratios delve into the operational efficiency of a firm, specifically how well it turns its assets into revenue or how quickly it manages its liabilities. These ratios allow businesses to identify areas that may require improvement and help external stakeholders understand a company’s operational strengths or weaknesses.

The primary focus of efficiency ratios is on a company’s management of resources such as inventory, accounts receivable, working capital, and other key operational assets. These metrics indicate how effectively a firm can convert assets into cash flow or sales by optimizing processes and operations. The ability to improve operational efficiency directly impacts a company’s profitability, as higher asset utilization allows firms to achieve economies of scale, reduce costs, and boost revenue generation.

Among the most commonly used efficiency ratios are Inventory Turnover Ratio, Days Sales Outstanding Ratio, and Working Capital Turnover Ratio, among others. These ratios serve as critical performance indicators for businesses and stakeholders who rely on financial data to make informed decisions.

The Inventory Turnover Ratio, also referred to as the Rate of Stock Turnover, measures how quickly a company sells and replaces its inventory over a specific period, such as a fiscal year. This ratio provides valuable insights into inventory management practices and indicates the efficiency of a company’s supply chain and sales processes. A high Inventory Turnover Ratio suggests that the company is selling its inventory quickly, which is generally positive because it minimizes the risk of inventory obsolescence and reduces holding costs. On the other hand, a low Inventory Turnover Ratio could indicate poor sales, overstocking, or inefficient inventory management. It implies that a company might be tying up too much capital in inventory, which can lead to cash flow issues. Efficient inventory management allows companies to maintain a balance—keeping enough stock to meet customer demand without overcommitting resources to excess inventory.

Another important efficiency ratio is the Days Sales Outstanding (DSO) Ratio, which measures the average number of days it takes for a company to collect payments from its credit sales. The DSO is a reflection of a company’s accounts receivable management and how effectively it converts credit sales into cash. A lower DSO indicates that the company collects its receivables quickly, which enhances liquidity and reduces the risk of cash flow disruptions. Conversely, a high DSO could signal inefficiencies in credit control, difficulties in customer payments, or a lenient credit policy. Monitoring DSO over time allows a company to assess trends and determine whether its receivables are being collected promptly. Improved receivables collection can ensure that the business has the cash needed to meet its operational and strategic objectives.

The Working Capital Turnover Ratio is another widely used efficiency ratio that evaluates how effectively a company utilizes its working capital to generate sales. Working capital, defined as current assets minus current liabilities, is a measure of a company’s short-term financial health. The Working Capital Turnover Ratio measures the relationship between sales revenue and the amount of working capital used to generate those sales. A higher ratio indicates that a company is using its working capital efficiently to produce revenue, meaning that it can generate sales with a lower amount of capital invested in short-term assets and liabilities. Conversely, a low Working Capital Turnover Ratio suggests that the company is not effectively leveraging its available working capital to support operations and generate sufficient revenue. Efficient use of working capital enables a business to optimize cash flow, reduce excess inventory, and maintain financial flexibility.

Efficiency ratios like these provide significant insights into a company’s operational management, liquidity, and overall performance. They allow businesses to assess their ability to manage assets, control costs, and streamline processes to maximize profitability. While profitability ratios may show whether a company is generating profits, efficiency ratios show how effectively a company is deploying its resources to achieve those profits. As such, they are often used in combination with profitability and liquidity ratios to give a well-rounded analysis of a company’s financial condition.

The importance of efficiency ratios extends beyond a firm’s internal analysis. External stakeholders such as investors and creditors use these ratios to evaluate operational performance and predict a company’s ability to generate profits and maintain liquidity over time. For example, creditors often examine the Inventory Turnover Ratio and DSO to determine whether the company has enough liquidity to meet its short-term obligations and repay debts. Similarly, investors may look at Working Capital Turnover Ratios to determine how efficiently a company can generate sales from its assets and how likely it is to produce steady returns.

However, it is important to note that efficiency ratios should not be analyzed in isolation. A comprehensive understanding of a company’s financial performance and operational management requires combining these ratios with other financial indicators. For instance, a high Inventory Turnover Ratio might appear positive but could indicate that a company is struggling to meet unexpected increases in customer demand if inventory levels are too low. Likewise, a low DSO might seem favorable but could lead to reduced market competitiveness if a company adopts overly strict credit policies that alienate customers.

Another limitation to consider is that efficiency ratios are based on historical data from financial statements, which may not always provide an accurate or up-to-date reflection of market conditions. Seasonal fluctuations, changes in customer demand, technological advancements, or other external market forces can affect how efficiently a company uses its assets and liabilities. Therefore, trends and industry comparisons are essential when interpreting these ratios. Comparing a company’s efficiency ratios to those of competitors in the same industry can provide additional insights into how well a business is performing relative to market peers.

Overall, efficiency ratios are indispensable financial tools that allow companies and external stakeholders to assess how well resources are being managed. Ratios such as the Inventory Turnover Ratio, Days Sales Outstanding Ratio, and Working Capital Turnover Ratio are key indicators of operational performance. They show whether a company is converting assets into sales, managing credit policies effectively, and optimizing its working capital to support revenue generation. By monitoring these ratios over time and in the context of industry standards, companies can identify operational inefficiencies, improve financial management, and ensure long-term profitability. Likewise, external investors and creditors can rely on these ratios to assess the financial stability, operational agility, and growth potential of the companies they are considering for investment or credit.

Efficiency ratios are not just numbers on a financial report but strategic metrics that can guide decision-making processes. They represent a company’s ability to streamline operations, maintain cost control, and sustain profitability through better resource management. A company that continuously improves its efficiency ratios demonstrates agility, strategic foresight, and a commitment to long-term growth—qualities that are vital for staying competitive in dynamic market environments.

Learn how to calculate these ratios with the following example:

Calculate the relevant efficiency ratios, given the following information:
Accounts payables $380,000
Accounts receivables $290,000
Credit sales $500,000
Cash sales $400,000
Credit purchases $390,000
Cash purchases $40,000
Cost of sales $450,000
Opening inventory $100,000
Closing inventory $80,000
Bank $50,000
Buildings $600,000
Motor vehicles $110,000
Fixtures and fittings $70,000

Solution:
(1) Total Assets Turnover = Net Sales / Total Assets = (500,000 + 400,000) / 1,200,000 = 0.75 times
(2) Inventory Turnover Ratio = Cost of sales / Average inventory held = 450,000 / 90,000 = 5 times
(3) Inventory Turnover Period = (Average inventory / Cost of sales) * 365 Days = (90,000 / 450,000) * 365 = 73 days
(4) Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts receivables = 500,000 / 290,000 = 1.72 times
(5) Average Collection Period = (Average receivables / Credit Sales) * 365 Days = (290,000 / 500,000) * 365 = 211.7 days
(6) Accounts Payable Turnover Ratio = Net Credit Purchases / Average payables = 390,000 / 380,000 = 1.03 times
(7) Average Payment Period = (Average payables / Credit Purchases) * 365 Days = (380,000 / 390,000) * 365 = 355.6 days

Workings:
Fixed assets = Buildings + Motor vehicles + Fixtures and fittings = 600,000 + 110,000 + 70,000 = $780,000
Current assets = Accounts receivables + Closing inventory + Bank = 290,000 + 80,000 + 50,000 = $420,000
Total Assets = Fixed assets + Current assets = 780,000 + 420,000 = $1,200,000
Average inventory held = (100,000 + 80,000) / 2 = $90,000