What is Efficiency Ratio and why it is important?

Definition for efficiency-ratio-and-why-it-is-important

Efficiency ratio is the ratio between assets and liabilities of the company. It analyzes that how much company utilizing its assets and liabilities with efficiency.

It helps an organization to know whether the business making the best use of its resources and generating adequate sales from its investment in equipment and people.

Funds are invested in various assets in business to make sales and earn a profit. The efficiency with which assets are managed directly affects the volume of sales. The better the management of assets, the larger is the amounts of sales and profit.

Efficiency ratios measure the efficiency or effectiveness with which a firm manages its resources or assets. These ratios are also called turnover ratios because they indicate the speed with which assets are converted or turn over into sales.

Some commonly used ratios are

  • Account receivable turnover
  • Fixed asset turnover
  • Sales to inventory
  • Sales to Net working capital
  • Account payable to sales
  • Stock turnover ratio

 

Weakness of Efficiency Ratio

The current ratio and acid test ratio give misleading results if current assets include the high amount of accounts receivable due to slow credit collection. In the same manner, a current ratio may further mislead if the assets include the high amount of slow moving inventories. As both these ratios ignore the movement of current assets, it is important to calculate the turnover or efficiency ratios to comment upon the efficiency with which the liquid resources are being used by the firm.

 

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