ComplianceLegalFinanceTax & AccountingSeptember 13, 2020

Efficiency ratios

As a business owner/manager, you're concerned with making the best use of your assets and being a low-cost producer in your industry. You can determine how efficiently your business uses its assets, and where there's room for improvement, by looking at the following ratios:

  • ratios for inventory analysis
  • ratios for accounts receivable analysis
  • fixed asset turnover
  • total asset turnover

Understanding ratios for inventory analysis

Inventory is the amount of merchandise, parts, supplies or other goods your business keeps on hand to meet the demands of your customers. Depending on the nature of your business (e.g., retail, wholesale, service, manufacturing), the efficiency of your inventory management may have a significant impact on your cash flow and, ultimately, your business's success or failure.

The following inventory analysis tools can be used to help manage your investment in inventory:

Understanding ratios for receivables analysis

Accounts receivable represent sales for which payment has not yet been collected. If your business normally extends credit to your customers, the payment of accounts receivable is likely to be your single most important source of cash inflows.

The following analysis tools can be used to help determine the effect your business's accounts receivable is having on your cash flow:

An increasing average collection period could indicate that action should be taken to increase collection activities and to tighten your credit policy. For more on how to improve your collection activities, see our discussion of improving your collection cycle.

Understanding fixed asset turnover

Fixed asset turnover is the ratio of sales (on your income statement) to the value of your fixed assets (on your balance sheet). It indicates how well your business is using its fixed assets to generate sales.

Generally speaking, the higher the ratio, the better. A high ratio indicates your business has less money tied up in fixed assets for each dollar of sales revenue. A declining ratio may indicate that you've over-invested in plant, equipment or other fixed assets.

Understanding total asset turnover

The ratio of total sales (on your income statement) to total assets (on your balance sheet) indicates how well you're using all your business assets (rather than just inventories or fixed assets) to generate revenue.

A high asset turnover ratio means a higher return on assets, which can compensate for a low profit margin. In computing the ratio, you might compute total assets by averaging the total assets at the beginning and end of the accounting period.

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