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Efficiency Ratios

Making the Most of Your Assets

Efficiency ratios help you evaluate how efficiently you are managing certain key balance sheet assets and liabilities.

The phrase managing the balance sheet may have a peculiar ring, especially since many company owners focus mainly on managing their business’s checkbook, or at best the income statement. But think about it: the balance sheet lists assets and liabilities, and these assets and liabilities are always in flux. If you can reduce inventory or speed up collection of receivables, you will have a direct and immediate impact on your company’s cash position. Efficiency ratios let you know how you’re doing on just such measures of performance. (We’ll have more to say on managing the balance sheet in part 7.)

INVENTORY DAYS AND INVENTORY TURNOVER

The first two ratios that we will discuss can be a little confusing. They’re based on the fact that inventory flows through a company, and it can flow at a greater or lesser speed. Moreover, how fast it flows matters a lot. If you look at inventory as frozen cash, then the faster you can get it out the door and collect the actual cash, the better off you will be.

So let’s begin with a ratio sporting the catchy name days in inventory, or DII. (It’s also called inventory days.) Essentially, it measures the number of days inventory stays in the system. The numerator is average inventory, which is beginning inventory plus ending inventory (found on the balance sheet for each date) divided by 2. (Some companies use just the ending inventory number.) The denominator is cost of goods sold (COGS) per day, which is a measure of how much inventory is actually used in each day. Here are the formula and sample calculation based on the information for the imaginary company in appendix A:

(Financial folks tend to use 360 as the number of days in a year, just because it’s a round number.) In this example, inventory stayed in the system for 74.2 days. Whether that’s good or bad, of course, depends on the product, the industry, the competition, and so on.

Inventory turns, the other inventory measure, is a measure of how many times inventory turns over in a year. If every item of inventory was processed at exactly the same rate, inventory turns would be the number of times per year you sold out your stock and had to replenish it. The formula and sample calculation are simple:

In the example, inventory turns over 4.85 times a year. But what are we actually measuring here? Both ratios are a measure of how efficiently a company uses its inventory. The higher the number of inventory turns—or the lower the inventory days—the tighter your management of inventory and the better your cash position. So long as you have enough inventory on hand to meet customer demands, the more efficient you can be, the better. In 2006 Target had inventory turns of 6.30—a pretty good number for a big retailer. But Wal-Mart’s turns were 7.84, even better. In the retail business, a difference in the inventory turnover ratio can spell the difference between success and failure; both Target and Wal-Mart are successful, though Wal-Mart is certainly in the lead. If your company has a significant amount of inventory, you need to track these ratios carefully. They are key levers that can be used by financially intelligent entrepreneurs to build a more efficient organization.

DAYS SALES OUTSTANDING

Days sales outstanding, or DSO, is also known as average collection period and receivable days. It’s a measure of the average time it takes to collect the cash from sales—in other words, how fast customers pay their bills.

The numerator of this ratio is ending accounts receivable, taken from the balance sheet at the end of the period you’re looking at. The denominator is revenue per day—just the annual sales figure divided by 360. The formula and sample calculation look like this:

In other words, it takes this company’s customers an average of about fifty-four days to pay their bills.

DSO is a wonderful tool for entrepreneurs. That one number offers an avenue for rapid improvement in your company’s cash position. Look at the sample company’s number: it is taking a long time for customers to pay their bills. Customers are holding the cash that belongs to the company for an average of fifty-four days. If this were the case at your company, you would want to ask why is it taking so long. Are customers unhappy because of product defects or poor service? Are salespeople too lax in negotiating terms? Are they not following up with customers when an invoice hits its term (say, at thirty days)? Are invoices taking too long to reach the customer? Does the company need updated financial management software? DSO does tend to vary a good deal by industry, region, seasonality, and the state of the economy, but still: if this company could get its ratio down to forty-five or even forty days, it would improve its cash position considerably. This is a prime example of an important phenomenon, namely that careful management of basic administrative tasks—paperwork—can improve a business’s financial picture even with no change in revenue or costs.

DSO is also a key ratio for anybody doing due diligence on a potential acquisition. A high DSO may be a red flag. Maybe the customers themselves are in financial trouble. Maybe the target company’s operations and financial management are poor. Maybe, as was the case at Sunbeam, there is some fast-and-loose financial artistry going on. We’ll come back to DSO in part 7, on the management of working capital; for the moment, note only that it is by definition a weighted average. So it’s important that the due diligence looks at the aging of receivables—that is, how old specific invoices are and how many there are. It may be that a couple of unusually large, unusually late invoices are skewing the DSO number (see the toolbox for part 7).

DAYS PAYABLE OUTSTANDING

The days payable outstanding (DPO) ratio shows the average number of days it takes a company to pay its own outstanding invoices. It’s sort of the flip side of DSO. The formula is similar: take ending accounts payable and divide by COGS per day:

In other words, this company’s suppliers are waiting a long time to get paid—about as long as the company is taking to collect its receivables.

So what? Isn’t that the vendors’ problem to worry about, rather than this company’s owner or managers? Well, yes and no. The higher the DPO, the better a company’s cash position, but the less happy its vendors are likely to be. A company with a reputation for slow payments may find that top-of-the-line vendors don’t compete for its business quite as aggressively as they otherwise might. Prices might be a little higher, terms a little stiffer. A company with a reputation for prompt thirty-day payment will find the exact opposite. If you depend on your vendors for frequent deliveries, good prices, or access to the latest and greatest products, paying them within their terms helps you maintain good relationships—and that, in turn, helps ensure that your company will get what it needs. Watching DPO is a way of making sure that your company is sticking to whatever balance it wants to strike between preserving its cash and keeping vendors happy.

PROPERTY, PLANT, AND EQUIPMENT TURNOVER

Property, plant, and equipment turnover tells you how many dollars of sales your company gets for each dollar invested in property, plant, and equipment (PPE). It’s a measure of how efficient you are at generating revenue from fixed assets such as buildings, vehicles, and machinery. The calculation is simply total revenue (from the income statement) divided by ending PPE (from the balance sheet):

By itself, $3.90 of sales for every dollar of PPE doesn’t mean much, but it may mean a lot when compared with past performance and with competitors’ performance. A company that generates a lower PPE turnover, other things being equal, isn’t using its assets as efficiently as a company with a higher one. So check the trend lines and the industry averages to see how your company stacks up. (If you run a service company you may not have much PPE on your balance sheet, so this ratio won’t tell you much about your business.)

At any rate, please note that sneaky little qualifier, “other things being equal.” The fact is, this is one ratio where the art of finance can affect the numbers dramatically. If a company leases much of its equipment rather than owning it, for instance, the leased assets may not show up on its balance sheet. Its apparent asset base will be that much lower and its PPE turnover that much higher. A lease must meet specific requirements to qualify as an operating lease (which may not show up on the balance sheet) as opposed to a capital lease (which does). Check with your accountant before entering into any kind of lease to see what its effects will be.

TOTAL ASSET TURNOVER

Total asset turnover is the same idea as the previous ratio, but it compares revenue with total assets, not just fixed assets. (Total assets, remember, includes cash, receivables, and inventory as well as PPE and other long-term assets.) The formula and calculation:

Total asset turnover gauges not just efficiency in the use of fixed assets; it gauges efficiency in the use of all assets. If you can reduce inventory, total asset turnover rises. If you can cut average receivables, total asset turnover rises. If you can increase sales while holding assets constant (or increasing at a slower rate), total asset turnover rises. Any of these managing-thebalance-sheet moves improves efficiency and ultimately increases cash, so the ratio is important to a start-up. Watching the trends in total asset turnover shows you how you’re doing.

There are many more ratios than these, of course. Financial professionals of all sorts use a lot of them. Investment analysts do, too. (A familiar one to public-company investors is the price-to-earnings ratio, which shows the relationship between a company’s stock price and its earnings or profits.) Your own organization is likely to have specific ratios that are appropriate for the company, the industry, or both. You need to determine the ratios that are important in your business and then calculate and interpret them. That will provide plenty of information to help you decide how to address the financial status of your company. The ratios we have outlined here are the most common for most business owners.

Although understanding the financial statements is important, it is just a start on the journey to financial intelligence. Ratios take you to the next level; they give you a way to read between (or maybe underneath) the lines, so you can really see what is going on. They are a useful tool for analyzing your company and for telling its financial story.

Are you ready to practice pulling the three statements together and calculating some ratios? You’ll learn a lot by doing it, rather than just reading about it. Please turn to the ratio exercise in appendix B.