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Efficiency Ratios

Efficiency Ratios: Inventory, AR, Average Collection, Fixed Asset, Total Asset Turnover



Efficiency ratios, as the name implies, provide information about how well the company is using its assets to generate sales. For example: if two firms have the same level of sales, but one firm has a lower investment in inventories, we would say that the firm with lower inventories is more efficient with respect to its inventory investment.

There are many different types of efficiency ratios that could be defined. However, we will illustrate five of the most common.



Inventory Turnover Ratio

The inventory turnover ratio measures the number of dollars of sales that are generated per dollar of inventory. It also tells us the number of times that a firm replaces its inventories during a year. It is calculated as:

                                                 Cost of Goods Sold
Inventory Turnover Ratio = —————————————————


Note that it is also common to use sales in the numerator. Since the only difference between sales and cost of goods sold is a markup, this causes no problems. In addition, you will frequently see the average level of inventories throughout the year in the denominator. Whenever using ratios, you need to be aware of the method of calculation to be sure that you are comparing “apples to apples”.


For 2004, ROYAL BALI CEMERLANG’s inventory turnover ratio was:

Inventory Turnover Ratio = —————————————– = 3.89 times


Meaning that ROYAL BALI CEMERLANG replaced its inventories about 3.89 times during the year.

Alternatively, we could say that ROYAL BALI CEMERLANG generated $3.89 in sales for each dollar invested in inventories.

Notice that this ratio has deteriorated somewhat from 4 times in 2003 to 3.89 times in 2004. Generally, high inventory turnover is considered to be good because it means that storage costs are low, but if it is too high the firm may be risking inventory outages and the loss of customers.


Accounts Receivable Turnover Ratio

Businesses grant credit for one main reason: to increase sales. It is important, therefore, to know how well the firm is managing its accounts receivable. The accounts receivable turnover ratio (and the average collection period, below) provides us with this information. It is calculated by:

                                       Turnover Ratio Credit Sales
A/R Turnover Ratio = ———————————————-
                                       Accounts Receivable


For ROYAL BALI CEMERLANG, the 2004 accounts receivable turnover ratio is (assuming that all sales are credit sales):

A/R Turnover Ratio = —————————- = 9.58 times


Whether or not 9.58 is a good accounts receivable turnover ratio is difficult to know at this point. We can say that higher is generally better, but too high might indicate that the firm is denying credit to creditworthy customers (thereby losing sales). If the ratio is too low, it would suggest that the firm is having difficulty collecting on its sales. This is particularly true if we find that accounts receivable are increasing faster than sales over a prolonged period.


Average Collection Period

The average collection period tells us, on average, how many days it takes to collect on a credit sale.

                                                    Accounts Receivable
Average Collection Period = —————————————————–
                                                    Annual Credit Sales / 360


Note that the denominator is simply credit sales per day. In 2004, it took ROYAL BALI CEMERLANG an average of 37.59 days to collect on their credit sales:

Average Collection Period = ————————————– = 37.59 days
                                                  3,850.00 / 360

Found that in 2003 the average collection period was 36.84 days which was slightly better than 2004. Note that this ratio actually provides us with the same information as the accounts receivable turnover ratio. In fact, it can easily be demonstrated by simple algebraic manipulation:

A/R Turnover Ratio = ———————————————-
                                       Average Collection Period

or alternatively:

Average Collection Period = ——————————————————-
                                                   Accounts Receivable Turnover Ratio

Since the average collection period is (in a sense) the inverse of the accounts receivable turnover ratio, it should be apparent that the inverse criteria apply to judging this ratio. In other words, lower is usually better, but too low may indicate lost sales.


Fixed Asset Turnover Ratio

The fixed asset turnover ratio describes the dollar amount of sales that are generated by each dollar invested in fixed assets. It is given by:

Fixed Asset Turnover = ——————————————————
                                           Net Fixed Assets


For ROYAL BALI CEMERLANG, the 2004 fixed asset turnover is:

Fixed Asset Turnover = ————————————– = 10.67 times


Total Asset Turnover Ratio

Like the other ratios discussed in this section, the total asset turnover ratio describes how efficiently the firm is using its assets to generate sales. In this case, we look at the firm’s total asset investment:

Total Asset Turnover = ————————————————–
                                          Total Assets


In 2004, ROYAL BALI CEMERLANG generated $2.33 in sales for each dollar invested in total assets:

Total Asset Turnover = ——————————————- = 2.33 times


You should see that the 2003 value was 2.34, essentially the same as 2004. We can interpret the asset turnover ratios as follows: Higher is better. However, you should be aware that some industries will naturally have lower turnover ratios than others. For example: a consulting business will almost surely have a very low investment in fixed assets, and therefore a high fixed asset turnover ratio. On the other hand, an electric utility will have a large investment in fixed assets and a low fixed asset turnover ratio. This does not mean, necessarily, that the utility company is more poorly managed than the consulting firm. Rather, each is simply responding to the demands of their industry.

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