The basic premise of efficiency ratio (also called activity ratio) analysis is to show the ability of a company to generate revenue from its assets.
As such, it is one of the cornerstones in evaluating management performance through financial statement analysis.
Below we will dive deeper into the most commonly used efficiency ratios. We will do this through defining the ratio, the formula, how to use it for efficiency ratio analysis and finally, demonstrate the use of the ratio through analysis of Coca Cola and PepsiCo.
These ratios are thus used by both insiders (management) and outsiders (debt- and equity holders) of the company
Efficiency ratios are closely related to profitability analysis – one could say that the two go hand in hand. This is due to the simple fact that profitable companies are often efficient companies.
Further, after reading this page, you will know whether Coca Cola or PepsiCo has performed the best in the last four years.
(Hint: It’s PepsiCo).
Accounts receivable (AR) turnover ratio
The definition of the accounts receivable turnover ratio formula is:
It shows how effective a company’s credit policies are.
Accounts receivable (AR) turnover ratio analysis
If the accounts receivable ratio is low, it may indicate that the company is giving too many credit lines to its customers.
A high accounts receivable ratio impacts a company in two ways:
#1 Ties more capital in the company, as the only options for funding a credit line is to increase equity or debt.
To see this assume you give a customer credit for 90 days, but you need the money in 60 days. When the 60 days are gone, you will either have to increase debt or increase equity to fund operations for the next 30 days until you receive payment.
#2 Higher default risk. Say you sell a product to a customer. If you give a 90 days’ credit line there is a small change that between now and then, the company may go bankrupt. In situations where that is a worry, an alternative could be to not give a credit line.
Accounts receivable (AR) turnover ratio example
As always here at FinanceFluent, we will use Coca Cola and PepsiCo as examples in our financial statement analysis.
Over the period, Coca Cola has seen a positive development, whereas PepsiCo has seen a steady development.
This ratio is thus very favourable for Coca Cola, as it basically shows, that they have been able to improve this ratio in an environment, where their largest competitors has seen a stable development.
Another thing to note is that we don’t have figures for 2012.
The ratio says that we should use the average AR over the period. This is defined as (beginning AR + end of period AR) / 2. As beginning of period AR is equal to end of last period AR we thus have (AR end of last period + AR end of this period) / 2.
Accounts payable (AP) turnover ratio
The definition of the accounts payable turnover ratio formula is:
It measures how a company manages paying its own bills.
Accounts payable (AP) turnover ratio analysis
Accounts payable is basically the opposite of the accounts receivable ratio. This is also highlighted in a lower ratio being better than a higher ratio.
A high accounts payable ratio may be a signal that a firm is not receiving favourable terms from its suppliers.
Accounts payable (AP) turnover ratio example
We have already established that Coca Cola are better at managing accounts receivable, but what about accounts payable?
It turns out that it is quite the opposite – PepsiCo are much better at getting good terms than Coca Cola.
Another thing to note is that while Coca Cola has improved their terms somewhat (1.0x), PepsiCo has done even better by improving it at a ratio of 1.4x!
Inventory turnover ratio
The definition of the inventory turnover ratio formula is:
It measures how well a company manages its inventory levels
Inventory turnover ratio analysis
The inventory turnover ratio shows, how many times a year, the company sells its inventory.
For creditors, the inventory turnover ratio is also important. It basically shows how liquid the inventory is. The more liquid, the better it is to put up as collateral for loans as it is easy to sell.
It basically shows, how easily the inventory can be turned into cash.
As such, a higher ratio is better than a lower ratio.
A low ratio can be interpreted in a variety of ways.
#1 The company cannot sell its inventory. Quite simple, if the company can’t sell it, it sits in the inventory
#2 Overstocking. If you have inventory for the next 90 days, and you get new deliveries you are overstocking (gross example). In this scenario, you could easily have inventory for 10 days and still be on the safe side when there suddenly is a spike in demand and restock the day after.
Inventory turnover ratio example
So, who’s better at turning over their inventory – Coca Cola or PepsiCo?
It turns out that PepsiCo has a significantly better ratio compared to Coca Cola and while Coca Cola has seen a steady development, PepsiCo has seen a large increase.
The PepsiCo increase of 0.8x to 9.7x can be interpreted as PepsiCo turning over its inventory almost another “full turn” every year.
Days’ sales in inventory ratio
The definition of days’ sales in inventory turnover ratio formula is:
It shows how many days it on average takes for the inventory to be sold. It is closely tied to the inventory turnover ratio.
Days’ sales in inventory ratio analysis
The ratio shows how many days the current inventory of a company is expected to last.
The interpretation of the ratio is the same as for inventory turnover with one important distinction.
A lower ratio is (all else equal) better, however, it is also highlights how very low ratios can create problems.
To see this assume that you have a Days’ sales in inventory ratio of 30 days.
However, the worst thing happens and your factory burns down (morbid example, we know – and remember, just an example).
Now you cannot produce anything and it will take 40 days before it is operational again.
For the first 30 days the ratio goes down by one day each day, however, after 30 days it is 0 and you can no longer sell anything.
Which you of course could see coming when the ratio was 20, 10 and 5. It came closer but there was nothing to do.
So a very low ratio can be a warning sign, but… all else equal, a low ratio is better.
Days’ sales in inventory ratio example
Remember the days’ sales in inventory ratio was closely tied to inventory turnover ratio?
And that PepsiCo had a better turnover ratio?
As such we would expect PepsiCo to have the best (lowest) days’ sales in inventory ratio.
This is also the case. Coca Cola’s has been steady and stable whereas PepsiCo has improved their ratio year on year.
Asset turnover ratio
Definition of asset turnover ratio formula is:
It shows how much revenue a company is able to generate of its assets in a year.
Asset turnover ratio analysis
The asset turnover ratio is a catch-all efficiency measure as it incorporates all assets in the firm, i.e. total assets.
It is a very pure efficiency measure and the higher the ratio the better.
To see this, consider a company that has one tractor. The more revenue you can generate from this one tractor, the higher the ratio.
As the ratio incorporates all assets of the firm it is a measure frequently used by both investors and creditors of the firm.
Asset turnover ratio example
Do we expect to see any picture in regards to who performs better between Coca Cola and PepsiCo in regards to what we have seen so far?
The answer is yes. We have seen Pepsi having better inventory ratios so this would favour them. Further, they also have a much lower accounts payable and although Coca Cola has a better accounts receivable ratio, this was by a shorter margin than Pepsi.
The picture is very clear! PepsiCo has a significantly higher asset turnover ratio than Coca Cola and has improved it over the last couple of years. On the other hand, Coca Cola has seen their ratio decline.
Below we have presented the trend for both companies.
It started so well with the accounts receivable ratio for Coca Cola, but after that it has been all Pepsi.
If this was a game of football, Coca Cola won the first quarter (accounts receivable) by a field goal and lost the remaining quarter by a touchdown (at least).
Now it’s your turn
This concludes our introduction to efficiency ratio analysis.
We encourage you to either try it yourself (that is the best way of learning) or move on to other topics within financial statement analysis, profitability ratios, liquidity ratios or solvency ratios.
We hope you enjoyed it and if you have any comments please post them below.
Or perhaps, you have questions about a step in the process?
We’ll be around to reply and answer questions.
So, if you have a question or a thought, leave a comment right now.