5.4 Efficiency ratios
Investors, lenders and suppliers are particularly interested in an evaluation of how efficiently a company is operating. Efficiency ratios are the ratios that allow you to evaluate the performance of an organisation by considering its operating efficiency. An efficient organisation in this context is one that chooses the appropriate pool of assets and uses them in such a way that the maximum return is made for shareholders over time.
The cycle of production
The cycle of production refers to the process whereby cash, possibly after some period of credit, is used to purchase inputs (raw materials/services/goods), which are processed in some way to produce the organisation’s output (finished goods/services). The finished goods/services are sold for cash or create accounts receivable (also known as debtors), which are ultimately converted back to cash when the customers pay what is owed for the goods or services they have bought. By exploring this somewhat simplified representation of the cycle, you can begin to look at the risks that an organisation may face at each stage of the cycle of production. You can also systematically calculate ratios that will alert you to any trends or changes in the efficiency of aspects of production relative to other players in the sector.
Efficiency ratios aim to measure a company’s effectiveness in employing a company’s resources in production. For example, if a factory produced 1,000 laptops for sale in 2024, it was less efficient than the same factory producing 2,000 laptops in 2025 for sale as the factory is now better utilised if more laptops are produced from it. The efficiency ratios reflect on the revenues produced by the business from the amounts invested in business operations. These ratios include:
- asset utilisation ratio
- inventory turnover ratio
- receivables collection period
- payables payment period.