Efficiency Ratio: Meaning, Types, Formulas and Limits

A company needs goods, machines and customers who pay on time. An efficiency ratio shows how well it uses these to earn sales. Investors use these ratios to compare a company with its past years and with similar companies.

• Turnover ratios show how many times a year something is used up or collected.
• Days ratios turn inventory, receivables and payables turnover into the number of days, using 365 days a year.
• The main ratios cover inventory, the goods a company holds; receivables, money customers owe it; and payables, money it owes suppliers.
• What counts as a good ratio depends on the industry.
• For banks, the ratio is costs divided by income, so a lower figure is read as better.

Efficiency ratios describe past performance from published accounts. They do not predict share prices or profit, and one ratio alone can mislead.

This type of ratio compares a company’s sales or costs with something it uses to earn them, such as its inventory or its assets. It shows how much in sales the company earns from what it holds.

These ratios use figures from two parts of an annual report. The profit and loss statement shows sales and costs over a year. The balance sheet shows what the company owns and owes on one date. For most Indian companies, this is 31 March, the end of the financial year under Section 2(41) of the Companies Act, 2013.

Because the balance sheet shows one date, analysts usually take an average of the opening and closing figures:

Average = (Opening figure + Closing figure) ÷ 2

These ratios are also called activity ratios or turnover ratios. They sit alongside other measures investors use, such as the price-to-earnings (P/E) ratio and earnings per share.

There are seven common ratios. Four measure turnover, how many times a year something is used up, sold or collected. Three turn turnover into days.

Cost of goods sold, often written COGS, is the direct cost of the goods a company sold in the year.

Net credit sales are sales made on credit, after returns. Many companies do not report credit sales separately, so analysts often use total sales instead. The ratio is then less precise.

You calculate each ratio by taking two figures from the annual report and applying its formula. The example below uses one hypothetical company for every ratio.

Hypothetical inputs for one year (₹ crore):

For the same year, net sales were ₹1,200 crore, credit sales were ₹900 crore and COGS was ₹720 crore.

Results:

Hypothetical figures, used only to explain the method.

So this company holds goods for about 60.8 days and waits about 60.8 days for customers to pay. It pays its own suppliers in about 45.6 days.

Some analysts combine the three day counts into the cash conversion cycle:

Cash conversion cycle = Days of inventory + Days of receivables − Days of payables

Here, 60.8 days + 60.8 days − 45.6 days = 76.0 days. That is roughly how long the company’s own money is tied up between paying suppliers and collecting from customers.

No. A higher turnover is often read as better, but the meaning depends on the ratio, the industry and the type of company.

For a bank, the efficiency ratio works the other way. It is usually worked out as operating expenses ÷ total income × 100, so a lower figure is read as better. Total income here means net interest income plus other income. This is also called the cost-to-income ratio. A bank with a ratio of 45% spends ₹45 to earn every ₹100 of income.

The industry changes what a normal figure looks like. A grocery retailer sells its stock many times a year. A heavy machinery maker may sell it only two or three times. Comparing the two tells you little.

Investors check four things to judge how much weight to give a turnover ratio: the trend, similar companies, profit and cash flow.

The ratios can show how well a company has used what it holds to earn sales. They cannot show whether its shares are good value.

These ratios describe past performance. They do not predict profit or share prices.

The ratios can mislead when the figures behind them do not reflect a normal year.

• Seasonal business: A company that builds stock before summer, such as an air-conditioner maker, may show high inventory on 31 March, even if stock is low for most of the year.
• One-off events: A large order, a plant shutdown or a sale of assets can distort one year’s ratios.
• Acquisitions: Buying another company adds its assets and inventory at once, before a full year of its sales is counted.
• Accounting choices: Companies can value inventory and record sales in different ways, so ratios are not always comparable.
• Missing credit sales: When credit sales are not reported separately, total sales are used, which can make receivables look better.

• Different years: Comparing companies with different year-end dates mixes figures from different periods.

  
  

These ratios show how much of a company’s cash is tied up in stock and unpaid bills. Cash that is tied up cannot be used to grow the business, pay debt or pay dividends.

Hypothetical scenario: Kavita is a salaried investor who holds shares in a company. She reads its annual report each year. She sees that days of receivables rose from 60.8 days to 70.8 days, while credit sales stayed at ₹900 crore.

She works out how much more money is now waiting to be collected:

Extra money tied up = Credit sales ÷ 365 × Extra days

₹900 crore ÷ 365 × 10 days = about ₹24.7 crore

Hypothetical figures, used only to explain the method.

That ₹24.7 crore has been earned as sales but not yet collected. The company may need to borrow to cover it, which adds interest costs. If some customers never pay, the company may have to write off part of it as a loss.

Kavita uses this to ask further questions about the company. A worse ratio does not mean the share price will fall, and a better one does not mean it will rise. This example describes one hypothetical investor’s reading. It is not a recommendation to buy, hold or sell any share.

Investors usually read these ratios together with the rest of the annual report. These are questions they ask before relying on one.

• Which industry is the company in, and what figures are normal there?
• Are you comparing the same ratio over at least three years?
• Did the company buy another business or sell part of its own this year?
• Is the business seasonal, so that year-end figures look unusual?
• Has the company reported credit sales separately, or is total sales being used?
• Have profit margins fallen while turnover has risen?
• Does cash flow from operations rise along with better ratios?
• For a bank, are you reading a lower cost-to-income ratio as better?