## Efficiency ratios

##### Published: Jul 2004

Investors will want to assess how efficiently a company uses its assets. There are a number of different ratios which can be used.

These ratios can be used in two ways. Firstly the ratio can be compared with the ratios of other companies in the same industry. Secondly these ratios should be compared over time, as this will suggest whether the situation is improving or deteriorating.

1. ##### Collection period ratio or days sales outstanding (DSO)

This ratio gives the time it takes the company to translate its receivables into cash. Any figure over the company’s regular payment terms suggests the common practice of late payment. It also suggests the company is being forced to borrow additional funds to finance its working capital. A low figure should indicate an efficient collection process, but it may mean the company’s credit policy is too restrictive. The figure can vary a lot during the year as the accounts receivable figure is taken at a point in time. More sophisticated analysis will average the accounts receivable figure throughout the year, but this data is not available from published accounts.The ratio is calculated using the following formula and will give a result in days:$$DSO = \frac{ Total \: accounts \: receivable }{Total\: annual \:sales} \times \: 365$$

2. ##### Sales to inventory ratio

This ratio shows how quickly a company translates its inventory into sales. In general, a higher figure suggests an efficient operation. However, this requires further investigation as it may suggest that a company is understocked and therefore missing key sales. If the figure is low, it may suggest that it is overstocked or that the company operates in a cyclical business cycle. This ratio is another measure of working capital management. The figure can also vary a lot during the year as the inventory levels may be subject to seasonal variation.This is calculated using the following formula = $$\frac{ Total\: annual \:sales }{inventory}$$

3. ##### Assets to sales ratio

This ratio shows how effectively the company uses both its fixed and variable assets. A high figure could suggest that the company is not being aggressive enough in the market place or that it has excess capacity. A low figure could suggest that the company is working close to capacity and that it could be susceptible to cash flow problems.This is calculated using the following formula =$$\frac{ Total\: assets}{total \: annual \:sales}\:$$ In some cases, companies will be assessed on the ratio of net working capital to sales. This is more appropriate in industries which require significant capital investment.

These ratios are in common use by both investors and corporate finance managers. It is important to remember that any assessment of this nature cannot stand alone. Rather, these ratios should be used as a tool to assess a company’s performance and as an indication that improvements are or are not being made. These ratios should always be used either in the context of past performance or in relation to similar companies in the sector.