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.
Key Takeaways
- The efficiency ratio is usually 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.
- An efficiency ratio can also track and analyze the performance of commercial and investment banks.
- Analysts use efficiency ratios tomeasure the performance of a business’s short-term or current performance.
- Banks refer to the efficiency ratio as non-interest expenses/revenue. This shows how well bank managers control overhead expenses and allows analysts to assess the performance of commercial and investment banks.
- The formula for the efficiency ratio for banks is expenses (not including interest) divided by revenue.
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What Does the Efficiency Ratio Tell You?
Efficiency ratios,alsoknown as activity ratios,are used by analysts tomeasure 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 various aspects of the company, such as the time it takes to collect cash from customers or 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 with 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
In the banking industry, an efficiency ratio has a specific meaning. For banks, the efficiency ratio is non-interest expenses/revenue. This shows how well the bank’s managers control their overhead (or “back office”) expenses.
Like the efficiency ratios above, this allows analysts to assess the performance of commercial and investment banks.
Formula for EfficiencyRatio for Banks
EfficiencyRatio=RevenueExpenses††notincludinginterest
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.
An efficiency ratio of 50% or under is considered optimal. If the efficiency ratio increases, it means a bank’s expenses are increasing or its revenues are decreasing.
For example, Bank X reportedquarterly earnings and had anefficiency ratio of 57.1%, which was lower than the 63.2% ratio it reported for the same quarter last year. This means the company’s operations became more efficient, increasingits assets by $80 million for the quarter.
What Does an Efficiency Ratio Measure?
An efficiency ratio measures a company’s ability to use its assets to generate income. It often looks at various aspects of the company, such as the time it takes to collect cash from customers or to convert inventory to cash. An improvement in efficiency ratio usually translates to improved profitability.
What Does the Efficiency Ratio Mean in Banking?
An efficiency ratio has a specific meaning for banks. It is referred to as non-interest expenses/revenue and shows how well bank managers control their overhead (or “back office”) expenses.
How Do Analysts Use Efficiency Ratios?
Analysts use efficiency ratios tomeasure the performance of a business’s short-term or current performance. All of these ratios use numbers in a firm’s current assets or current liabilities, quantifying the operations of the business.
The Bottom Line
The efficiency ratio typically analyzes how well a company uses its assets and liabilities internally. It can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and machinery. It can also be used to track and analyze the performance of commercial and investment banks.
