Efficiency Ratios

This first ratio can be found using the company's income statement and balance sheet. Cash turnover tells the analyst how many times a company replenishes cash with revenues. Generally, a high cash turnover ratio is better than a low one.

Formula

Cash Turnover = Revenues / Average Cash and Cash Equivalents

Interpretation

Comparisons should be performed between companies in similar industries. Ideally, an analysis should also include the trends of this measure over time. Companies with higher values are indicative of more efficiently run businesses. This first ratio is a very broad measure of performance.

This next metric tells the analyst how well a company manages inventory. Once again, this measure takes information from both the income statement and balance sheet. Typically, higher values of inventory turnover are a positive sign.

Formula

Inventory Turnover = Revenues (or Cost of Goods Sold) / Average Inventory

Interpretation

The numerator of this equation contains one of two values:

• The revenues flowing into the company each year, or

• The costs to produce the items that will eventually flow through inventory

The cost of goods sold variation provides the analyst with a clearer picture of inventory turnover. For example, if a company's ratio is equal to 12, this tells us the company's products remain in inventory for approximately one month. This is why higher values are considered better. However, a very high ratio may also indicate the company does not have enough capacity to meet demand for its product.

The convenience of credit, and relatively attractive repayment terms, results in the vast majority of revenues starting out as accounts receivable. This brings us to the next measure of efficiency: accounts receivable turnover. This measure tells the analyst how effective a company is at managing the credit they're extending to customers.

Formula

Accounts Receivable Turnover = Revenues / Average Accounts Receivable

Interpretation

Here again revenues are in the numerator, while the average accounts receivable for the year is in the denominator. If credit customers repaid money owed every thirty days, the accounts receivable turnover rate would be around 12. In this calculation, we're making a simplifying assumption that all revenues begin as credit sales.

Typically, most companies require retail credit customers to repay balances in 30 to 60 days. This translates into accounts receivable turnover ratios that are between 6 and 12. If this ratio falls too low, it can indicate problems collecting money from customers. When making comparisons between companies in the same industry, higher numbers should equate to more efficiently run companies.

Companies value having cash on hand. So while it's desirable for companies to be paid quickly for their products (money in), it's also desirable to delay payments to suppliers and trade partners (money out). The accounts payable turnover rate measures how long it takes to pay these suppliers.

Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable

Interpretation

This ratio contains an expense in the numerator. The cost of goods sold includes both raw materials (received from suppliers) as well as labor; so the relationship between the numerator and denominator is not as strong as accounts receivable turnover. A relatively high accounts payable turnover may indicate less than favorable payment terms. Once again, when attempting to determine the quality signal from a ratio, it's important to use an industry benchmark.

A discussion of efficiency ratios would not be complete without mentioning the cash conversion cycle. This metric not only tells the analyst how much cash is tied up in inventory, but also its ability to collect money owed by customers as well as payments made to creditors.

Formula

Cash Conversion Cycle (CCC) = DIO + DSO - DPO

Where:

• DIO = Average Inventory / (Cost of Goods Sold / 365)

• DSO = Average Accounts Receivable / (Revenues / 365)

• DPO = Average Accounts Payable / (Cost of Goods Sold / 365)

Interpretation

As the above formula demonstrates, this metric combines three sub-measures:

• DIO = Days Inventory Outstanding, which measures the efficiency of turning inventory into revenue.

• DSO = Days Sales Outstanding, which measures how effectively a company collects money from customers.

• DPO = Days Payable Outstanding, which measures how quickly a company pays its suppliers.

Our article dedicated to the cash conversion cycle, provides additional information on this very important measure, as well as an example to illustrate its usefulness.

Financial ratios are simple to calculate, typically requiring only a few data points from the income statement or balance sheet. They're useful when trying to understand the performance of a company relative to a competitor or industry benchmark.

They're also a snapshot in time, and historical performance is not always indicative of future results. Finally, these measures should be used as a guide. They're meant to augment other types of financial ratios as well as elements of fundamental stock picking theory such as earnings per share growth rates and value investing.