Measuring Efficiency and Operating Ratios
Efficiency and operating ratios measure overheads as a percentage of operating revenues or fee income; in effect, they measure how efficiently a company is being operated.
They are generally favored in the banking and financial sectors as a guide to a management's ability to keep overheads low. These ratios are also used in established industries, such as those in the steel, chemicals, and auto production sectors, where the focus is on tight cost controls to maintain profitability because the potential for growth from other bases is limited. They can also be applied to the efficient use of credit, the management of assets, and stock control, which reveals how fast a manufacturer or retailer is moving merchandise.
Efficiency and operating ratios are calculated by dividing operating overheads by revenue—including tax equivalent net interest income. If operating expenses are $100,000, and revenue (as defined) is $230,000 then:
Some analysts include all non-interest expenses in the calculation, while others exclude certain charges and intangible asset amortization.
To find the stock turnover ratio, divide total, net sales revenue by total stock. If net sales revenue is $300,000 and stock is $100,000, then:
To find the accounts-payable-to-sales ratio, divide accounts payable by annual net sales revenue. A high ratio suggests that a company is using its creditor's funds as a source of cheap financing rather than operating efficiently enough to generate its own. If accounts payable are $50,000 and total sales are $300,000, then:
- Identifying overheads to calculate efficiency and operating ratios can itself contribute to overall inefficiency. Some analysts maintain that efficiency can be measured just as well by reviewing earnings-per-share growth and return on capital invested. Some identify amortization of goodwill expense, and separate it from non-interest expense in order to calculate what is called the "cash-efficiency ratio"-that is, non-interest expense minus goodwill amortization expense divided into revenue.
- An acceptable efficiency and operating ratio in banking 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 capital invested and earnings.
- Another method of gauging efficiency is to monitor other measures, such as creditor and debtor days.
- In some sectors, efficiency ratios are called the "overhead burden"—overheads as a percentage of sales revenue&emdash.
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