Calculating Efficiency Ratios

Systems and Coordination

Calculating Efficiency Ratios

Calculating Efficiency Ratios provide additional insights into business operations. These are useful in helping an investor or lender spot key problem areas related to inventory management, cash flow, and collections. Here are the most common efficiency ratios...

Dr. David L. HarkinsOctober 5, 2017

Efficiency Ratios provide additional insights into business operations. These are useful in helping an investor or lender spot key problem areas related to inventory management, cash flow, and collections.

These ratios include:

INVENTORY TURN-OVER RATIO

The Inventory Turn-Over Ratio measures how long it takes for inventory to be sold and replaced during a period (typically a year.) The formula is as follows:

Inventory Turnover = Cost of Goods Sold/Average Inventory*

The longer inventory sits on the shelf, the more it costs the company because gross profit is not realized from the sale. Sales and inventory management are key measures for investors.

*Average Inventory = (Beginning Inventory+Ending Inventory)/2

AVERAGE COLLECTION PERIOD RATIO

The Average Collection Period Ratio measures the average number of days customers take to pay for products or services. The formula is as follows:

Average Collection = Account Balances for the Year/Net Sales for the Year

A short average collection period compared to industry standards is preferred by investors.

If you would like to learn more about Financial Ratios and how they may be used, read the post, Financial Ratio Analysis and the Entrepreneur.

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Reference

Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.

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