Question

What are the efficiency ratios, and what do they measure? Why, for some firms, is the total asset turnover more important than the fixed asset turnover?

Answer 1

Efficiency ratios are the ones that measures how well or efficiently, the company is managing its assets as well as the liabilities. It is a measure which is used to find out the current performance of the company. These ratios are calculated by using the values of the assets and liabilities of the company. It tells us about hoe efficiently the assets of the company are employed to generate the returns. These ratios are usually compared with the other firms in the same industry to find out the performance of the company relative to the other firms in the industry.

Major Efficiency turnover ratios are:-

1) Asset Turnover Ratio:- The asset turnover ratio helps in finding out the ability of the company to efficiently generate revenues from its assets.

Asset Turnover = Net Sales Revenue / Average Total Assets

With the help of this ratio we can find out how many sales are generated from each dollar of assets of a company.

2) Receivables Turnover Ratio:- The receivables turnover helps in finding out the efficiency of a company in actively collecting its debts.

Receivables Turnover = Net credit sales / Average accounts receivable

Higher receivable turnover is better for the company which means that company is efficiently collecting its amount from its customers. And if it is low then it means that the company is having difficulty in collecting from its customers.

3) Inventory Turnover Ratio

The inventory turnover ratio helps in finding out the ability of the company to manage its inventory efficiently and it also provides valuable information regarding the sales of the company. This ratio measures how many times the total average inventory has been sold over the course of a period.

Inventory Turnover = Cost of Goods Sold / Average Inventory

Higher inventory turnover ratio is preferable as it indicates that the inventory has been managed well, otherwise if it is low then the company is either overstocking the inventory or facing an issue with their sales.

For some firms, the total asset turnover is more important than the fixed asset turnover as the total asset turnover ratio helps in knowing how much revenue is generated by employing every $1 of average assets and on the other hand fixed asset turnover ratio helps in finding out how much revenue is generated by employing every $1 dollar of fixed assets. So, for some firms, fixed assets may remain same for a long period of time and by using the fixed asset turnover ratio, the true image of the performance of the company is not reflected in such cases. The fixed asset ratio is generally not very consistent in the sense that even if the revenue is growing consistently, it is not necessary for fixed assets to have a smooth pattern.Whereas, total asset turnover ratio tends to indicate true image of the performance of the company as it takes into every kind of asset that are current assets, long-term investments, fixed assets, and intangible assets. So this ratio indicates efficiency in using all of these assets instead of only one i.e. fixed assets in case of fixed asset turnover ratio.