Calculating Popular Efficiency Ratios
Using information from the balance sheet and income statement, this calculator provides an estimate of the five most common efficiency ratios. The calculator requires a total of six inputs, including from the income statement:
- The company’s revenues for the accounting period in question, sometimes referred to as sales
- The cost of goods sold
From the balance sheet we need the following:
- Cash and cash equivalents, which is a current asset
- Accounts receivable and inventory, which are also current assets
- From the current liabilities section of the balance sheet, we need accounts payable
Using this information, the calculator then provides the user with four turnover ratios, including:
- Cash, accounts receivable, inventory and accounts payable
We can also calculate the company’s cash conversion cycle, or CCC
What are Efficiency Ratios?
Efficiency ratios provide analysts with insights into how well management leverages its assets and liabilities. In this case, we are evaluating how efficient management is at using its cash, turning over its inventory, paying its bills, and collecting money from its customers. We also have the cash conversion cycle, which is arguably the most important benchmark used to compare this type of efficiency performance to other companies. Let’s take a closer look at each of these metrics:
- Cash Turnover: this ratio is calculated by dividing cash by revenues and allows the analyst to understand how effectively management is using cash to generate sales / revenues.
- Accounts Receivable Turnover: this ratio is calculated by dividing accounts receivable by revenues / sales and allows the analyst to understand how many times the company is able to collect accounts receivable from customers. It’s also an indication of management’s ability to control its credit policy.
- Inventory Turnover: also known as the stock turnover ratio, the inventory turnover ratio allows analysts to understand how well management is able to control inventory. It is calculated by taking average inventory and dividing it by the cost of goods sold.
- Accounts Payable Turnover: this ratio is calculated by taking the cost of goods sold and dividing it by average accounts payable. Also known as payables turnover, this ratio tells analysts the average times a company pays creditors. This ratio is actually a measure of liquidity too.
- Cash Conversion Cycle: also known as the net operating cycle, the cash conversion cycle, or CCC, is the sum of three metrics. DSO, which is the number of days sales are outstanding, DIO which is the number of days inventory is outstanding, minus DPO which is a measure of the days payables are outstanding. CCC is a measure of how well the company’s management team manages cash.
Interpreting the Results of Our Calculator
Efficiency ratios are best used to compare, or benchmark, the performance of companies in similar industries. The following are general rules of thumb for each of these ratios:
- Cash Turnover: higher numbers are better because it means less cash is needed to generate revenues
- Accounts Receivable Turnover: higher numbers are better because it means accounts receivable is low relative to revenues
- Inventory Turnover: higher numbers are better because inventory stock is low relative to the cost of goods sold
- Accounts Payable Turnover: lower values are better because it means the company is relatively slow paying their creditors
- Cash Conversion Cycle: finally, lower numbers are better since it means cash used in all areas of the company are generating sales faster (in fewer days)