Ratio Analysis and Interpretation: Efficiency Ratios

 To judge the overall financial health of a company, analysis of some ratios from the financial statements can prove to be useful. 

Ratio analysis is used to evaluate the relationship between financial statements. Various ratios can be used to identify trends over time for one company or to compare two or more companies. Additionally, ratio analysis helps you judge all the companies on the same metrics, despite the differences between their volumes of sales, the costs that they incur, etc.

Ratio analysis can be used for the following purposes:

• To evaluate performance over time
• To evaluate performance against industry average
• To evaluate performance against peers

There are four categories of ratios that will help you perform a critical evaluation and delve deeper into the figures mentioned in the financial statements. The categories are as follows:

1. Liquidity Ratio
2. Solvency Ratio
3. Profitability Ratio
4. Efficiency Ratio

Efficiency ratios:

Suppose you are the manager of an FMCG company, and you decide to start a variety of company products. This will require more machine goods to increase production and more money to meet the growing costs associated with diversity. 

This investment in machinery, i.e. fixed assets, and cash, i.e. current assets, is a major investment of the company. After investing so much money, it is important to understand how assets work.

Are you able to reap more benefits from your investment? Do you use your resources to the fullest?

Efficiency ratios also known as activity ratios, check how a company measures its operations or assets. The company is said to be on the right track if it can enjoy high profits and high efficiency.

There are multiple ratios within this category that can be used depending upon the purpose. The two main ratios are as follows:

Asset turnover ratio: It measures a company’s ability to use its assets.

• A lower number may indicate higher levels of unsold inventory.

• It is calculated using the following formula:

Asset turnover ratio	=	Total revenue
		Total assets

Inventory turnover ratio: It shows the number of times a business sells and replaces its entire batch of inventories.

• A low turnover indicates poor inventory management.

• It is calculated using the following formula:

Inventory turnover ratio	=	COGS
		Average inventory

where average inventory is (opening inventory (Year 0)+ closing inventory (Year 1))/2

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