Efficiency Ratios
Efficiency ratios or activity ratios helps to calculate how well business firms use their assets to bring in the income. Efficiency ratios usually measures the time it takes companies to accumulate cash from customer or the time it taken by companies to convert inventory into cash, in simpler words, make sales. The management uses these ratios to help improve the company together with outside investors and creditors looking at the operations of profitability of the company.
Efficiency ratios and profitability ratios are sort of interdependent. Generally, it is considered that when companies are utilising their resources efficiently, they are likely to become profitable. Any company which is good at selling low margin products at greater volumes can be a good example because they are efficient at turning their assets.
Efficiency ratios that are used commonly are:
Accounts Receivable Turnover Ratio
Accounts receivable turnover is a part of efficiency ratio that calculates how often a business can convert its accounts receivable into cash during a given period of time. Simply put, the accounts receivable turnover ratio calculates how many times a business can collect its average accounts receivable during the year.
The formula to calculate Accounts Receivable Turnover Ratio is:
Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable
Working Capital Ratio
The working capital ratio aslo kniown as current ratio, is a liquidity ratio that calculates a firm's ability to clear off its current liabilities with current assets. The working capital ratio is a significant factor to creditors because it reflects the liquidity of the business firm.
Current assets like cash, cash equivalents, and marketable securities are best suited to clear off the current liabilities because these assets can be converted into cash much faster and easier than fixed assets. The quicker the assets convert into cash, the more chances the company will have the cash in time to clear off its debts.
The formula to calculate Working Capital Ratio is:
Working Capital Ratio = Current Assets/Current Liabilities
The Asset Turnover Ratio
The asset turnover ratio is a part of the efficiency ratios that calculates if a company is able to bring in sales from its assets by putting net sales with average total assets into comparison. Simply put, this ratio reflects how effectively a company utilises its assets to bring in sales.
The total asset turnover ratio measures net sales as a percentage of assets to show the number of sales generated from each dollar of assets of the company. For example, a ratio of .6 shows that each dollar of assets generates 60 cents of sales.
The formula to calculate Asset Turnover Ratio is:
Asset Turnover Ratio = Net Sales/Average Total Assets
