Efficiency ratio: what is it and how to use it?
In 2021, the New York Stock Exchange had approximately 2,500 listed companies. The all-digital NASDAQ had more than 3,700. With so many publicly traded companies, investors need a quick and consistent way to evaluate each company. To do this, they turn to the efficiency ratio. Let’s take a look at what an efficiency ratio is and how you can use it to your advantage.
What is an efficiency ratio?
An efficiency ratio, also known as an activity ratio, is a measure that tells a company how well it is using its resources to make a profit. Efficiency ratios are like the titles of chapters in a book. They don’t tell you the whole story. But reading them will still give you a good idea of what the story is about. Efficiency ratios use a company’s assets and liabilities to quantify business operations.
The first thing to note is that there are many types of efficiency ratios. For example, some of the most common ratios are:
- Operating margin: Measures the profit a company makes per dollar of sales after variable expenses, but before interest and taxes. Divide operating profit by revenue.
- Price/earnings ratio: Indicates how much investors are willing to pay per share for 1 USD of profit. This ratio can determine whether a company is overvalued or undervalued. Divide the stock price by the earnings per share.
- return on assets: measures the efficiency with which a company uses its assets to generate a profit. Divide the company’s net income by its average assets.
- Return on equity: measures the efficiency with which a company generates a profit from its equity financing. Divide the company’s net profit by its equity.
- Stock rotation: Measures how quickly inventory is sold, replaced or used. Divide the cost of goods by the average inventory for the same period.
- Cash conversion: measures the efficiency with which a company converts its sales and income into cash. Divide operating cash flow by net income.
- Rate of endettement: measures the leverage used by a company. In other words, how much equity is available to cover the company’s outstanding debts. Divide total liabilities by equity.
As you can see, each of these efficiency ratios measures a different aspect of business operations. However, let’s take a closer look at what all this information means.
How do companies use this information?
Business owners use efficiency ratios to get an overview of their company’s performance over a period of time. These ratios also tell managers how well they are doing their job (running the business). Managers can use these metrics to benchmark themselves, their competition, and industry standards.
Managers can use efficiency ratios to see where the business excels. But, more importantly, managers can see what improvements can help. Efficiency ratios are a bit like a dashboard for the company. They tell the manager how the company ranks in different areas. From there, it’s up to the manager to figure out why a certain rating is bad and how best to improve it.
Cash conversion example
Let’s say you are the CFO of a company. You generate a report of business operations. In this report, you can see that your company’s cash flow conversion ratio is low (a perfectly efficient ratio is equal to 1). This tells you that your business is struggling to convert profits and sales into real money. If this low conversion rate persists, your business could have a potential liquidity problem. In other words, despite good sales, your business may run out of cash to pay expenses. If your business has a large unexpected expense, it could become insolvent.
Once you have this information, you can devise a plan to improve the company’s cash conversion. And there are several ways to do it. Start by establishing a company policy of net-15 payment terms. You can also offer your customers more payment options or modify your invoicing software.
This is just one example of how companies benefit from an efficiency ratio. But what if you’re not the CFO of a company. Why should you, as an investor, care about these measures?
How can you use this information?
As an investor, you can also take advantage of this information to make decisions. The difference is that you weren’t hired to solve business problems. Instead, you want to determine whether or not you should invest in the business.
Efficiency ratios are interesting measures because they are both simple and complex. The report itself is quite simple. However, understanding the context of the ratio is where it can get more complex. In other words, an efficiency ratio will tell you what is good or bad within a company. But he doesn’t tell you why. You will need to figure this out for yourself.
In fact, you can use efficiency ratios to value inventory. Each efficiency ratio will give you a little insight into the business as a whole. However, it is up to you as an investor to assess these parameters. Assess the big picture and decide whether or not to invest.
I hope you enjoyed learning how to use an efficiency ratio! Remember that I am not a financial adviser and simply offer my own research and commentary. As usual, please base all your investment decisions on your own due diligence.
A graduate of the University of Miami, Teddy studied marketing and finance while playing four years on the football team. He has always had a passion for business and has used his experience from a few personal projects to become one of the top rated business writers on Fiverr.com. When he’s not pounding words on paper, you can find him pounding notes on the piano or traveling to a random location.