Efficiency Ratios: Types & Formula

Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

Efficiency ratios identify the relationship between assets and sales in different ways. Learn the formulas and use of the different types of efficiency ratios: inventory ratios, days sales in inventory, and asset turnover ratio. Updated: 11/14/2021

What Are Efficiency Ratios?

Dan just landed a new job as a financial analyst at Webster Water Manufacturing Plant (WWMP). He meets with his boss to find out exactly what his tasks and responsibilities will be during the first week. Dan's boss, Stephanie, tells him his first order of business will be to analyze the manufacturing plant's efficiency and report his findings and suggestions.

A few weeks later, Dan meets with Stephanie and gives her a 20-page glossy report on the WWMP's efficiency. As Stephanie reviews the report, she looks unimpressed. She turns to Dan and says sternly, 'Dan, by efficiency, I meant for you to calculate how efficiently we are using our assets to generate sales, not how efficiently the plant is using electricity and solar power!'

Stephanie goes on to tell Dan that from a financial perspective, efficiency ratios show how well we are using our assets to generate sales. It's important to know WWMP's efficiency, and there are three main financial ratios that will provide a detailed overview: inventory ratio, days sales in inventory, and asset turnover.

For the rest of this lesson, we will discuss each ratio, the formula, and determine if a low or high result is positive or negative.

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  • 0:04 What Are Efficiency Ratios?
  • 1:28 Inventory Ratio
  • 3:23 Days Sales in Inventory
  • 4:34 Asset Turnover Ratio
  • 5:24 Lesson Summary
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Inventory Ratio

Efficiency ratios provide the company with specific data on how well they are using their assets to generate sales. Assets are items that WWMP owns. For example, the manufacturing plant is an asset in addition to the furniture in the office, trucks, company cars, cash, and inventory.

To analyze how well WWMP is purchasing and selling their inventory, we calculate the Inventory turnover ratio. The inventory turnover ratio is calculated by taking the cost of the goods sold (COGS) divided by inventory. Before we discuss the actual calculation, let's review what COGS is.

COGS, or the cost of goods sold, is the dollar amount of supplies WWMP purchases to make their product. Let's say they purchase string for $100, leather for $500, and plastic for $1,000 to make their widgets. Their supply costs to make the widgets would be $100 + $500 + $1,000 for a total of $1,600. $1,600 would be their COGS.

Now, let's calculate the inventory turnover ratio, which is cost of goods sold divided by Average inventory. Last year, WWMP sold 10,000 widgets, which each cost $1 to produce, so cost of goods sold is $10,000. WWMP had $2,000 in inventory on Jan 1 and $3,000 on 12/31, so we will take a two point average to get the average inventory:

($2,000 + $3,000) /2 = $2,500.

To find the inventory turnover ratio, we will divide the cost of goods sold by the average inventory:

Some companies use cost of sales instead of cost of goods sold in our formula.

$10,000 / $2,500 = 4 times

Inventory turnover ratios are different for each industry; however, WWMP executives would like to see the number get to 5 times next year. Faster turnover means more revenue for the inventory investment!

Now, let's look at the days sales in inventory, which identifies how many days on average it takes to sell our inventory.

Days Sales in Inventory

Days sales in inventory help us understand how many days the inventory we have in stock will last. Calculating this is easy once you have done the inventory turnover number:

Days sales in inventory = Days in the year / Inventory turnover ratio

= 365 / 4 = 91.25 days

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