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Efficiency ratio

What is the Efficiency Ratio?

The Efficiency ratio is one of the component of financial ratio analysis which is known for calculating that the company is going into profit or losing. The efficiency ratio is to check the accessibility and excitability of the activities, resources happening in the company to calculate its net income.

The Efficiency ratio is not like the other ratios because every ratio has its motive to calculate something but the efficiency ratio has the motive to calculate all the activities of a company such as assets, liabilities, revenue. In simple words, we can say that it is a bulk of many ratios.

What do you understand by the word “Efficiency”?

The word “Efficiency” for the company describes the capability, ability, capacity of the business activities, and how company members manage its activities within an effective period or given period. So exactly Efficiency ratio tells us how a company performed with its assets and handled its liabilities to get valuable profit.

  • The Efficiency ratio measures the company’s regular activities with its resources.
  • It checks the performance of the company by calculating all ratios which are the types of efficiency ratio such as inventory, asset, account receivables, or payables ratio.
  • It evaluates how a company can quickly generate its revenue in the current period of the financial year.
  • It analyzes the performance of the company with the other company in the same field.
  • It also shows the proficiency of the company’s presence in the market industry.
  • With this ratio, analysts try to get the output of the company’s overall performance for the whole year.

By the way, the company records its assets and liabilities in a double-entry system or single-entry system and by preparing financial accounts such as profit and loss, income statements, cash flow statements. So then analysts need a talented ratio which calculates all the things separately and gives accurate results

Variety of Efficiency ratio

There are four varieties of Efficiency ratio which are used to calculate a company’s ability to handle liabilities and use its assets with obstacles which keep on coming and going in the business. 

Inventory turnover ratio

In which ratio shows how many times the inventory is sold and resold in the whole year, quarterly, or monthly. Company analysis by using inventory turnover ratio = Cost of good sold/average inventory, inventory depends on sales of goods.

Ratio analyze

If the inventory turnover ratio indicates higher, it means the company’s sales department is working well and manages all its sales well. On the other hand, if the inventory turnover ratio indicates lower, it means the company’s sales department is not working well. This ratio indicates how the company manages the sales department.

Account receivable turnover ratio

In which ratio shows how the company gets back its bills against goods or services from its clients or customers. Account receivables are recorded under liabilities of the credit side. Account receivables turnover ratio = Revenue/average account receivable.

It shows how much a company gets revenue by receiving bills and loan payments from the customers or clients so that the company can also analyze sales and get profit.

Ratio analyze

If the account receivable turnover ratio indicates higher, it means the company quickly manages its account receivables and improves its credibility. On the other hand, if the account receivable turnover ratio indicates lower, it means the company can’t manage its credibility which badly affects the company’s status.

Account payables turnover ratio

In which ratio shows how the company pays their loan from banks or lenders within a given per Account payable such as Trade payables and Note payables are recorded under assets on the debit side. Account payables = Total Purchase/Average payables.

It shows how many things a company can purchase from lenders in the form of cash, goods, loan, etc.

Ratio analyze

If the account payable turnover ratio indicates higher so it means the company can’t handle their liabilities and can’t pay back to the lenders for their purchasing. It shows the company’s poor performance and goes into loss. On the other hand, if the account payable turnover ratio indicates lower, it means the company can handle its liabilities effectively without facing any loss and it shows the company’s good performance. 

Working capital turnover ratio

In which ratio shows how much a working capital company used for sales and resources turnover. It shows the liquidity of the business. Working capital turnover ratio = sales/ average working capital.

Ratio analyze

If the working capital turnover ratio indicates higher, it means the company uses its working capital well. On the other hand, if the working capital turnover ratio indicates lower, it means the company can use its working capital in a better way and do more sales for getting effective revenue or output.

How does the bank get affected by the efficiency ratio?

As we said above, the efficiency ratio determines the capacity of individual activity and company’s activities mode that how they are performing with its assets and managing liabilities that are taken from lenders or such financial institutions or banks.

Well, banks also have a major effect on efficiency ratio because efficiency ratio is considered as a non-interest expense or revenue for them.

In simple words, if we calculate the efficiency ratio, it also analyses the bank’s financial status and describes how bank managers control their expenses and revenue. The lower efficiency ratio describes the bank is going on the right path means good operating by generating more revenue and the higher efficiency ratio describes the bank is not good at operating by generating less revenue.

So banks also give potential to the company so that they increase their income by generating more revenue. If we want to make the bank operating better so the company needs to apply some new technologies and stay with the current bank situations to improve data and reports.