Understanding Efficiency Ratios And Profitability Ratios

Understanding Efficiency Ratios And Profitability Ratios

Efficiency Ratios: This ratio defines a company’s expertise to manage its assets and liabilities effectively. The efficiency ratio is an indication of the judicious use of assets by the company to generate revenues.

Few efficiency ratios are discussed below:

  • Inventory Turnover Ratio: The inventory turnover measures how fast the inventory is moving through the firm and generating sales. Inventory turnover can be defined as “Cost of Goods Sold/Average Inventory. Higher the ratio, greater the efficiency of inventory management.
  • Asset Turnover Ratio: The asset turnover ratio measures the ability of the company to generate sales by using its assets in an efficient manner. The ratio usually is an indication of how much sales a company can generate by using its asset base. Asset Turnover Ratio can be defined as “Revenues/ Average total asset”.
  • Receivables Turnover Ratio: The receivables turnover ratio gives, how many times account receivable is converted into cash during the year and it can be defined as “Net Credit Sales/Average Accounts Receivable”.

Profitability ratio: This ratio finds out the ability of a company to generate profits in relation to its associated expenses. A higher value for the ratio generally indicates the good performance of the company. Few profitability ratios are discussed below:

  • Gross Profit Margins: This ratio indicates the profits related to sales after the direct production costs are deducted. It can be defined at “Gross Profit/Net Sales”.
  • Net Profit Margins: This ratio signifies the earnings left for the shareholders (both equity and preference) as a percentage of net sales. Net profit margin ratio can be defined as “Net Profit/Net Sales”.
  • Return on Assets: ROA measures how much return a company generates using its total assets. The formula can be stated as “Net Income/ Average Total Assets”. We calculate the denominator by using the average of beginning and ending total assets. We can also add back the interest expense to net income while calculating the formula to calculate operating returns before the cost of borrowing. This is more accurate in the sense that since total assets of the company denote both equity and debt, we may add back the cost of borrowing to get an accurate picture. In general, the higher the ROA the better it is since it indicates a superior performance by the company to generate returns, however, we must also know a decrease in total assets can also lead to a higher ROA.
  • Return on Equity: As the name suggests this is simply measured to find out the return the company has generated using only the capital of equity shareholders and does not include debt in it. This is a profitability ratio and can be calculated as “Net Income/Average shareholder’s equity”. The average shareholder’s equity is calculated by using an average of the beginning and ending equity. This ratio measures the profitability of equity funds invested in the company or firm and tells about how much profit a company can obtain in comparison to the total amount of shareholder equity.
  • Return on Capital Employed: It measures the profitability of the company. The formula for ROCE is EBIT/ capital employed. It measures how much return the capital is efficient to provide back to the capital employers of the company which includes Debt and equity. Hence, we use EBIT in the numerator to get the return before even providing for interest payments.

These are generally the efficiency and profitability ratios used, however, these ratios must be used in conjunction with other factors to get a better view of the company.


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