Efficiency Ratio:

Efficiency Ratio: Definition, Formula, Types, and Example

Definition

The efficiency ratio is a financial metric used to assess the operational efficiency of a business. It is calculated by dividing operating expenses by net sales. A higher efficiency ratio indicates lower efficiency, as it suggests a larger proportion of sales revenue is consumed by operating expenses.

Formula

Efficiency Ratio = Operating Expenses / Net Sales

Types of Efficiency Ratios

1. Asset Turnover Ratio
   • Measures how efficiently a company utilizes its assets to generate sales.
   • Formula: Net Sales / Average Total Assets
2. Inventory Turnover Ratio
   • Indicates how quickly a company converts inventory into sales.
   • Formula: Cost of Goods Sold / Average Inventory
3. Accounts Payable Turnover Ratio
   • Evaluates how efficiently a company pays its suppliers.
   • Formula: Accounts Payable / Average Accounts Payable
4. Operating Expense Ratio
   • Assesses the efficiency of a company’s operational activities.
   • Formula: Operating Expenses / Total Sales

Example Calculation

Consider Company ABC’s financial data for the year 2020:

• Net Sales: $1,000,000
• Operating Expenses: $200,000
• Average Total Assets: $800,000
• Cost of Goods Sold: $600,000
• Average Inventory: $400,000
• Accounts Payable: $100,000

The efficiency ratios for Company ABC are:

• Asset Turnover Ratio = 1,000,000 / 800,000 = 1.25
• Inventory Turnover Ratio = 600,000 / 400,000 = 1.5
• Accounts Payable Turnover Ratio = 100,000 / 100,000 = 1.0
• Operating Expense Ratio = 200,000 / 1,000,000 = 0.2

Conclusion

The efficiency ratio is a key financial metric for measuring a company’s operational effectiveness. By analyzing different types of efficiency ratios, businesses can gain insights into how well they utilize assets, manage inventory, and handle supplier payments. A lower efficiency ratio indicates better operational efficiency, leading to improved profitability and financial performance.