Efficiency Ratios Explained – Measure How Well a Business Uses Its Resources
Efficiency ratios show how effectively a business uses its assets, inventory, and working capital to generate revenue.
Unlike profitability ratios that focus on earnings, efficiency ratios focus on operational performance.
What Are Efficiency Ratios?
Efficiency ratios (also called activity ratios) measure how quickly and effectively a company converts resources into sales and cash.
What Efficiency Ratios Answer
- Are assets being used productively?
- Is inventory moving fast enough?
- Are customers paying on time?
- Is capital tied up unnecessarily?
Why Efficiency Ratios Matter
Even profitable companies can fail due to poor efficiency.
High efficiency means:
- Faster cash conversion
- Lower operating costs
- Better scalability
Low efficiency means:
- Idle assets
- Excess inventory
- Cash flow pressure
Major Types of Efficiency Ratios
🔹 Asset Efficiency Ratios
| Ratio | Formula |
|---|---|
| Total Asset Turnover | Revenue ÷ Total Assets |
| Fixed Asset Turnover | Revenue ÷ Fixed Assets |
🔹Inventory Efficiency Ratios
| Ratio | Formula |
|---|---|
| Inventory Turnover | Cost of Goods Sold ÷ Inventory |
| Days Inventory Outstanding (DIO) | 365 ÷ Inventory Turnover |
🔹 Receivables & Payables Ratios
| Ratio | Formula |
|---|---|
| Receivables Turnover | Revenue ÷ Accounts Receivable |
| Days Sales Outstanding (DSO) | 365 ÷ Receivables Turnover |
| Payables Turnover | COGS ÷ Accounts Payable |
Real Business Example (Very Important)
📊 Financial Data
| Item | Amount |
|---|---|
| Revenue | 800,000 |
| COGS | 500,000 |
| Inventory | 100,000 |
| Total Assets | 400,000 |
| Accounts Receivable | 80,000 |
📊 Financial Data
| Item | Amount |
|---|---|
| Revenue | 800,000 |
| COGS | 500,000 |
| Inventory | 100,000 |
| Total Assets | 400,000 |
| Accounts Receivable | 80,000 |
📈 Calculated Efficiency Ratios
- Inventory Turnover = 5.0
- DIO = 73 days
- Asset Turnover = 2.0
- DSO = 36 days
Interpretation of Results
Inventory Turnover = 5.0
- Inventory is sold 5 times per year
- Acceptable for manufacturing
- Low for retail (industry comparison needed)
DSO = 36 days
- Customers pay within a reasonable period
- Credit policy appears effective
Asset Turnover = 2.0
- Strong asset utilization
- Indicates operational efficiency
Industry Matters (Critical Insight)
Efficiency ratios vary widely by industry:
| Industry | Typical Asset Turnover |
|---|---|
| Retail | High |
| Manufacturing | Medium |
| Utilities | Low |
| Real Estate | Very Low |
⚠️ Never compare efficiency ratios across industries.
Improving Efficiency Ratios (Actionable Advice)
Improve Inventory Efficiency
- Reduce slow-moving stock
- Forecast demand better
- Optimize reorder levels
Improve Receivables Efficiency
- Shorten credit terms
- Follow up on overdue invoices
- Offer early payment discounts
Improve Asset Efficiency
- Dispose idle assets
- Increase capacity utilization
- Lease instead of buy
Efficiency Ratios vs Profitability Ratios
Efficiency drives profitability.
Better efficiency leads to:
- Lower costs
- Higher margins
- Stronger cash flow
Common Mistakes in Efficiency Ratio Analysis
Avoid these:
- Ignoring seasonal effects
- Using one ratio only
- Not comparing trends
- Overlooking operational context
Frequently Asked Questions
What is a good efficiency ratio?
It depends on industry benchmarks and business model.
Are higher efficiency ratios always better?
Not always — extremely high turnover may indicate stock shortages.
Do efficiency ratios affect cash flow?
Yes, directly through inventory and receivables cycles.
Can startups use efficiency ratios?
Yes, especially to control working capital.
Final Conclusion
Efficiency ratios reveal how well a business converts resources into revenue. They are essential for operational control, cash flow management, and long-term sustainability.
Used with liquidity and profitability ratios, they provide a complete financial picture.
According to Investopedia, efficiency ratios measure how effectively a company manages its assets.