16 Dec 2017

What is the ‘Efficiency Ratio’

The efficiency ratio is typically used to analyze how well a company uses its assets and liabilities internally. An efficiency ratio can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and machinery. This ratio can also be used to track and analyze the performance of commercial and investment banks.

BREAKING DOWN ‘Efficiency Ratio’

Analysts use efficiency ratios, also known as activity ratios, to measure the performance of a company’s short-term or current performance. All of these ratios use numbers in a company’s current assets or current liabilities, quantifying the operations of the business.

An efficiency ratio measures a company’s ability to use its assets to generate income. For example, an efficiency ratio often looks at aspects of the company, such as the time it takes to collect cash from customers or the amount of time it takes to convert inventory to cash. This makes efficiency ratios important, because an improvement in the efficiency ratios usually translates to improved profitability.

These ratios can be compared to peers in the same industry and can identify businesses that are better managed relative to the others. Some common efficiency ratios are accounts receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales and stock turnover ratio.

Efficiency Ratios for Banks

The efficiency ratio also applies to banks. For example, a bank efficiency ratio measures a bank’s overhead as a percentage of its revenue. Like the efficiency ratios above, this allows analysts to assess the performance of commercial and investment banks.

For a bank, an efficiency ratio is an easy way to measure the ability to turn assets into revenue. Since a bank’s operating expenses are in the numerator and its revenue is in the denominator, a lower efficiency ratio means that a bank is operating better. I’s believed that a ratio of 50% is the maximum optimal efficiency ratio. If the efficiency ratio increases, it means a bank’s expenses are increasing or its revenues are decreasing.

An Example of Efficiency Ratio

For example, Bankwell Financial Group Inc. reported second quarter 2016 earnings on July 27, 2016. The report stated that the financial group had an efficiency ratio of 57.1%, which was lower than the 63.2% ratio it reported for the same quarter in 2015. This means the company’s operations became more efficient; it increased its assets by $80 million for the quarter.

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