Efficiency Ratio

What is an 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.

What Does an Efficiency Ratio Tell You?

Efficiency ratios, also known as activity ratios, are used by analysts to measure the performance of a company's short-term or current performance. All 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 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 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.

The Efficiency Ratio for Banks Is:

Efficiency Ratio = Expenses † Revenue † not including interest \begin{aligned} &\text{Efficiency Ratio} = \frac{\text{Expenses}^{\dagger}}{\text{Revenue}} \\ &\dagger \text{not including interest}\\ \end{aligned} Efficiency Ratio=RevenueExpenses††not including interest

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 reported quarterly earnings and it had an efficiency 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, increasing its assets by $80 million for the quarter.