Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
In this lesson, we'll define efficiency ratios and discuss three examples of efficiency ratios: inventory ratio, days sales in inventory, and asset turnover ratio. You'll also learn how to calculate and analyze these ratios.
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.
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 purchased for $1 each, 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 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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WWMP's competitors are averaging about 75 days. Therefore, we are holding on to our inventory too long, and the older the inventory, the more obsolete, or out of date it is. Perhaps, WWMP management needs to work together to discuss another product line that can generate better sales. Stephanie is perplexed by WWMP's inventory ratio and days sales in inventory ratio; she asked Dan to calculate their asset turnover ratio, and maybe there will be a bit of sunlight.
Asset Turnover Ratio
The Asset turnover ratio shows how well we are using all of our assets to generate sales. The asset turnover ratio is calculated by taking sales divided by total assets.
Remember, WWMP's sales are $10,000, and their total assets are $50,000. $10,000/$50,000 equals 0.2. Therefore, for every dollar in assets, WWMP only generates $.20. WWMP's competitors average $.80 on every dollar, so our numbers are really low.
After Dan's analysis of the efficiency ratios, Stephanie realizes she needs to call a meeting immediately to discuss the future of WWMP.
Inventory ratio, days sales in inventory, and asset turnover are efficiency ratios, which show how well a company uses their assets to generate sales. Remember, assets are items the company owns, such as a building, truck, cash, or inventory.
The inventory turnover ratio is an efficiency ratio. It tells us how well we are purchasing and selling our inventory to generate sales. It is calculated by taking Sales / Average inventory. The lower the number, the less efficient we are in managing our inventory. We may be purchasing too much inventory or not selling enough.
The next ratio we discussed was the days sales in inventory ratio. This ratio explains how long the inventory we have in stock will last. It's calculated by taking The number of days in the year / Inventory turnover ratio. The higher number of days, the more obsolete the inventory, and the harder it will be to sell in the future.
Lastly, we reviewed the asset turnover ratio. This ratio showed us how well we're using all of our assets to generate sales. The asset turnover ratio is calculated by taking sales divided by total assets. A low asset turnover ratio shows our inefficiency to use those assets to make sales.
This lesson on efficiency ratios will provide the information you'll need to subsequently:
Provide the definition of efficiency ratios
Calculate inventory ratio, days sales in inventory ratio and asset turnover ratio
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