How to Calculate Efficiency Ratios
When examining stock analysis ratios, potential investors can look to efficiency ratios for important information about how a company converts its liquid assets, such as inventory, back to cash. The ratios also will reveal how long that process takes.
Businesses may use their assets to generate income in different ways. For instance, a business may receive cash upfront and pay suppliers later, and some businesses pay for inventory months before receiving it. Knowing which model a business uses can help uncover how effectively a company manages its resources.
Cash conversion cycles
The cash conversion cycle determines how many days it would take a company to convert its inventory into cash flow from sales. Turning over inventory quickly is ideal. Thus, the fewer days it takes, the better the company is at managing its cash.
Calculating cash conversion
The cash conversion cycle is the number of days inventory outstanding plus the number of days sales outstanding minus the days payables are outstanding. This information is gleaned from the income statement and the balance sheet.
Days Inventory Outstanding = 365 x (Avg. Inventory / COGS)
Days Sales Outstanding = 365 x (Avg Receivables / Sales)
Days Payables Outstanding = 365 x (Avg Payables / COGS)
Where the average of any of these measures is calculated by averaging the beginning and ending values.
Look at a company’s cash conversion cycle historical average and compare it to industry competitors to gain a better understanding of how a business is performing.
Inventory turnover ratio
The inventory turnover ratio – or “inventory turns” — shows how long it takes for a company to sell its inventory over a certain time period.
Calculating inventory turnover
When creating an inventory turnover formula, first determine a timeframe to examine – typically a quarter or fiscal year. The ratio then looks at the revenue during that period divided by the average inventory. Average inventory can be found by averaging the end and beginning costs of inventory over the time period you are measuring.
A company that turns its inventory into sales, then buys more inventory and again converts it into sales multiple times a year is probably doing better than a company that can’t sell its inventory.
When looking at inventory turnover, compare a company’s performance with a direct competitor as inventory turnover can vary greatly among industries.
Receivables turnover ratios
The receivables turnover ratio shows how effectively a company collects its credit sales owed by customers.
Calculating receivables turnover
Receivables turnover is an activity ratio calculated by looking at revenue over a period of time (ideally, just the sales made on credit) divided by average accounts receivable. The more times a company can turn its receivables, the more efficient it is at collecting debts.
Efficiency ratios offer some key methods to examine stocks and analyze a companies’ performance. Calculating various efficiency ratios can indicate factors such as how well a company is managed and performing.