Financial Analysis

Category 2: Efficiency Ratios
If you are running an efficient business you have to be continually concerned with making sure that you are using the best of your assets.

You can determine this by calculating some efficiency ratios to show if there is any room for improvement in your business operation.

The ratios affected here are:

  1. Stock turnover ratio.
  2. Accounts receivable turnover ratio.
  3. Fixed asset turnover.
  4. Total asset turnover.

1. Stock Turnover Ratio:
This ratio shows how well you are managing your stock. It is important to manage it well because the number of times your stock can be turned in a given operating cycle will contribute to your profit. The greater your turnover – the greater the profit. How efficiently you manage your stock could have a significant impact on your cash flow and ultimately on the profitability of your business.

The stock turnover ratio is calculated as follows:

                Stock turnover ratio = net sales over average stock at cost

2. Accounts Receivable Turnover Ratio:

Accounts receivable are sales for which you have not yet received payment. If you extend credit to your customers, the receipt of money from those customers is likely to be the single most important cash source for your business.

The accounts receivable turnover ratio shows how well your collections are being conducted. A bad turnover ratio will show it is taking longer and longer for you to collect money owing from customers. In this case you may have to rethink your whole collection policy. The slow receipt of money from customers will severely affect your business when liquidity is affected.

3. Fixed Asset Turnover:

Fixed asset turnover is the ratio of your sales to the value of your fixed assets. Your sales figure is the figure showing in your income statement and your fixed assets is the figure showing in your balance sheet.

The ratio will show how well your business is using its fixed assets to generate sales. In general, the higher the ratio the better because a high ratio shows your business has less money tied up in fixed assets for every dollar of sales generated. If your ratio is declining this could indicate that you have over-invested in your fixed assets such as plant and equipment etc.

4. Total Asset Turnover:
This is the ratio of total sales to total assets. Total sales are the figures showing in your income statement and the total assets are the figures showing in your balance sheet. This ratio will show how well you are using all your business assets rather than just fixed assets or stock to generate sales revenue. A high turnover ratio means you are obtaining a higher return on your assets, which can point to a low profit margin.