When analyzing a company's potential for investment, it is important to examine its financial performance from every angle. While metrics that measure a company's ability to turn profit are of paramount importance, the efficiency with which they do so also bears scrutiny. A company may be plenty profitable, but could it do more given the assets it has at its disposal? Efficiency ratios compare what a company owns to its sales or profit performance and inform investors about a company's ability to use what it has to generate the most profit possible for owners and shareholders.
There are numerous efficiency metrics that are easily calculated using the information made available on a company's financial accounting statements, such as its income statement or balance sheet. One of the most commonly used metrics is the asset turnover ratio. This ratio is used to compare a company's net sales to its total average assets. Net sales include all revenue from a business' primary operations minus any returns or discounts. A business' total assets are found on the balance sheet and include everything the company owns, including accounts receivable, real estate, machinery and intangible assets such as goodwill. The asset turnover ratio reflects the amount of sales revenue generated for every dollar invested in the company.
The fixed asset turnover ratio is a more refined efficiency metric. This ratio is used to compare a company's net fixed assets, rather than total assets, to its net sales. Net fixed assets include those tangible assets that provide operational benefit to the company for an extended period of time. This metric uses only fixed assets, which are typically comprised of a company's property, plant and equipment, or PP&E, minus depreciation costs, because these assets are directly used to produce goods for sale. By comparing sales to the value of these fixed assets, this efficiency ratio reflects a company's ability to put its long-term resources to use.
The inventory turnover ratio is especially important for retail businesses. The most accurate form of this calculation compares the cost of good sold, or COGS, to average inventory. The result is a ratio that indicates how many times a company sold through its average inventory during a given period. A high ratio is an indication the company enjoys healthy sales and is doing a good job of managing its inventory needs. A low ratio can be an indication of several issues, such as poor advertising, over-production or product obsolescence.
When analyzing these and other efficiency metrics, investors pay special attention to trends in a company's performance over time. Increasing ratios are a good indication a company is using its assets, managing production and driving sales effectively. Declining ratios mean sales are dwindling or the company is overly invested in facilities, equipment, inventory or other assets that are not generating additional revenue. However, revenue sometimes lags behind investment. For example, a mediocre fixed asset ratio one year may lead to a much healthier figure 12 months later as new equipment purchased the year before begins to contribute to increased production and sales. Similarly, a company may ramp up its inventory in preparation for a large sales event in the future, making the business look temporarily less efficient.