Efficiency Ratios Definition and Example
Efficiency Ratios Definition – “Financial measures that links various income statement and balance sheet figures to gauge a company’s operating efficiency”.
In simple words, efficiency ratios measures how efficient the company is making utilization of its assets in order to generate income. These ratios are also known as activity ratios. It also measures the time duration a company takes to get the cash from the customers plus the time duration for converting the inventory into cash. These ratios monitors the operational efficiency of the organisation. On the other hand, these ratios helps the stakeholders such as investors and creditors to monitor the profitability of the organisation.
Efficiency ratios and profitability ratios complement each other. If company is efficient that also implies that it is profitable. For example – Hindustan Unilever Limited .
Efficiency Ratios Example
To understand the efficiency ratios definition more clearly, let’s discuss few of its examples.
Accounts Receivable Turnover Ratio
This ratio measures how efficiently or in how many less days, business is able to convert its account receivables into cash. In simple words, this ratio measures the efficiency of collecting the company’s account receivables. The time period for collecting the receivables may vary. Some companies collect them in 3 months and some took near about 6 months.
Account Receivables Turnover Ratio = Net Credit Sales/Average Account Receivables
Example – The average accounts receivables of ABC company is Rs. 30,000. The credit sales that company makes is of Rs. 50,000.
So the accounts receivable turnover = 50,000/30,000
= 1.67 times
This means that ABC company collects the receivables 1.67 times a years or once in 278 days.
This ratio measures the company’s ability to pay off its current liabilities with the use of current assets. This ratio is very important from the perspective of creditors or who have invest their money in the business. As it shows the liquidity of the company.
It is always favorable for the business that it has sufficient amount of currents assets so that they are easily convertible into cash. If current assets exceeds the current liabilities, this indicates that business has the sufficient cash to pay off its current liabilities.
This ratio measures the efficiency of management in generating the sales from the assets available with the organisation. This efficiency ratio compares the net sales with that of average total assets. For example – a ratio of 0.75 indicates that with each rupee of assets, company has generated sales of 75 cents.
Inventory Turnover Ratio
This is another efficiency or activity ratio. This ratio measures how efficiently the management is clearing off the inventory during a period of time. It is the ratio of cost of goods sold with respect to average inventory.
This is another efficiency ratio which measures the days taken to clear off the inventory of the business. Or it tells about the time for which the inventory of a business lasts.
Related Financial Terms of Efficiency Ratio
- Liabilities Definition – Types of Liabilities | Examples
- Acid-Test Ratio Definition, Meaning Formula and Example