efficiency ratio

Fin

a way of measuring the proportion of operating revenues or fee income spent on overhead expenses.

EXAMPLE

Often identified with banking and financial sectors, the efficiency ratio indicates a management’s ability to keep overhead costs low. In banking, an acceptable efficiency ratio was once in the low 60s. Now the goal is 50, while better-performing banks boast ratios in the mid 40s. Low ratings usually indicate a higher return on equity and earnings.

     This measurement is also used by mature industries, such as steel manufacture, chemicals, or car production, that must focus on tight cost controls to boost profitability because growth prospects are modest.

     The efficiency ratio is defined as operating overhead expenses divided by turnover. If operating expenses are $100,000, and turnover is $230,000, then:

100,000/230,000 = 0.43 efficiency ratio

However, not everyone calculates the ratio in the same way. Some institutions include all non-interest expenses, while others exclude certain charges and intangible asset amortization.

     A different method measures efficiency simply by tracking three other measures: accounts payable to sales, days sales outstanding, and stock turnover. This indicates how fast a company is able to move its merchandise. A general guide is that if the first two of these measures are low and third is high, efficiency is probably high; the reverse is likewise true.

     To find the stock turnover ratio, divide total sales by total stock. If net sales are $300,000, and stock is $140,000, then:

300,000/140,000 = 2.14 stock turnover ratio

To find the accounts payable to sales ratio, divide a company’s accounts payable by its annual net sales. A high ratio suggests that a company is using its suppliers’ funds as a source of cheap financing because it is not operating efficiently enough to generate its own funds. If accounts payable are $50,000, and total sales are $300,000, then:

50,000/300,000 = 0.14 × 100 = 14% accounts payable to sales ratio