Measuring Efficiency

Understanding Efficiency

Efficiency measures how well a business uses its resources to achieve profit and meet its objectives.

Inventory Turnover: The number of times a company sells and restocks its inventory during a certain period. A high inventory turnover rate indicates superior sales and purchasing processes.
Accounts Receivable Turnover: How quickly a business collects debts from customers. A high rate may point to a strict credit policy or a customer base that pays promptly.
Operating Efficiency Ratios: Indicate the efficiency of a firm’s operating cycle or its sales efforts. Examples include sales-to-revenue, cost-of-goods-sold-to-sales, and return-on-investment.
Asset Turnover: The ratio of the value of a company’s sales or revenues generated to the value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with which a company is deploying its assets in generating revenue.

Revenue and Costs

Understanding both the source of income and also the nature of expenditure is important.

Sales Revenue Efficiency: It is the efficiency with which a firm transforms its resources into sales. Sales-to-asset ratio is one often-used indicator.
Cost Efficiency: The relationship between expenses and revenues. Lower expenses for a given level of revenue indicate a higher degree of cost efficiency.

Profit Margins

Examining profit margins can be useful to judge a company’s efficiency.

Gross Profit Margin: Reveals how much a company earns taking into consideration the costs that it incurs for producing its products and/or services. A high gross profit margin means that the company did well in managing its cost of sales.
Net Profit Margin: The percentage of revenue remaining after all operating expenses, interest, taxes and preferred stock dividends have been deducted from a company’s total revenue.

A good understanding of these ratios and what they can tell us about a business could be key to diagnosing potential problems or identifying strong performers.