Efficiency Ratios: A Complete Guide

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Dive into our Comprehensive Guide on How to Analyse Efficiency of a Business for Smarter Investment Decisions.

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As an investor, while analysing stocks, you must consider various factors to understand whether the stock is worth investing in or not. One common practice we all do is comparing the stock with its peers.

You would agree to this – in today’s cut-throat competitive business environment, a company with an edge over its competitors is not enough to make it a market leader. Every company is racing to be more efficient because efficiency is the key to staying ahead in the game. If a company is inefficient in managing its finances and operations, its competitors will inevitably take the lead.

As investors, we also want to invest in companies with efficient businesses. But the question is, how do you analyse a company’s efficiency?

Well, just by analysing efficiency ratios . These ratios give us insights into how efficiently a company uses its resources to generate revenue.

Here, we will explore different efficiency ratios and how they can help us evaluate a company’s overall efficiency through different aspects.

Inventory Turnover Ratio

A company is highly efficient if it manages to sell its manufactured inventory on time. No business wants to manufacture goods to store them in their godowns. Every company expects to sell its products as quickly as possible to earn profits from the sale. The longer a company takes to sell its inventory, the lower its inventory turnover ratio will be, which means low efficiency.

The inventory turnover ratio tells us how many times a company sells all its inventory or restocks its inventory in a given year.

The formula to calculate the inventory turnover ratio is dividing the Cost of Goods Sold (COGS) by the average inventory.

For example, Britannia Industries has an inventory turnover ratio of 15.4 (as of 3rd May 2023), meaning they sell their entire inventory 15.4 times a year. Whereas Nestle India has an inventory turnover ratio of 23.11 (as of 3rd May 2023), meaning that they sell their entire inventory 23.11 times a year. In this case, Nestle India is more efficient than Britannia Industries, indicating higher efficiency.

A high inventory turnover ratio is often viewed as a positive sign for a company, indicating strong product demand and efficient inventory management. When analysing a company’s inventory turnover ratio, it’s crucial to compare it with its peers in the same industry. Also, instead of doing a single-period exercise, it is great to look at a five-year trend and the reasons behind any odd movement in the ratio.

Asset Turnover Ratio

Have you ever noticed a tea seller using a cloth to strain the tea before serving it? By doing this, he ensures that the tea powder does not flow into your cup, and he can reuse the same tea powder to make more cups of tea.

This is an excellent example of how a tea seller uses his asset’s efficiently (the tea powder) to the optimum level to sell more tea and generate higher revenue.

In the business world, this efficiency is measured by the asset turnover ratio, which is calculated by dividing the sales achieved by the company by the assets (Net sales/ Average total assets). By analysing this ratio, investors can understand how well a company uses its assets to generate profits.

For example, if we look at the retail sector, the asset turnover ratio of Trent is 1.04, whereas Vedant Fashion has a ratio of 0.69 (both as of 3rd May 2023). Generally, the asset turnover ratio of retail businesses is higher because they have small asset bases but high sales volumes.

A higher ratio signifies that the company is using its assets well to generate higher revenue. In comparison, a lower ratio indicates that it may not be using its assets efficiently.

So, when analysing stocks from a particular sector, you need to compare the asset turnover ratio with its peers for better analysis.

Accounts Receivable Turnover Ratio

Have you ever had a friend who borrowed money from you but took ages to pay you back? Similarly, businesses have to deal with many clients who take goods on credit. If these clients don’t pay on time, it could lead to cash flow problems. That’s where the accounts receivable ratio comes in.

It measures how well a company is collecting payments from its clients. Moreover, this ratio measures the frequency with which a company collects its average accounts receivable balance over a specific period.

We simply divide the net credit sales by the average accounts receivable to calculate this ratio.

A higher ratio indicates that a company is able to collect payments more quickly, which is a good sign. On the flip side, a lower ratio could suggest that the company is having trouble collecting payments, which could lead to cash flow problems.

While analysing stocks, it’s important to compare a company’s accounts receivable turnover ratio to its peers in the same industry.

To conclude, efficiency ratios are essential for investors to analyse a company’s overall efficiency. These ratios give investors insights into how well a company uses its resources to generate revenue.

Overall, understanding and analysing efficiency ratios, among other ratios, is critical for investors to make informed decisions about their investments so as to figure whether the company they are investing in has an efficient management or not.

*The stocks mentioned in the article are for information only. This is not investment advice.

Note: This article was originally written by Teji Mandi for ET Markets.

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