Financial Ratios: E Ciency: Lesson 2.4
Financial Ratios: E Ciency: Lesson 2.4
Financial Ratios: E Ciency: Lesson 2.4
Lesson 2.4
Financial Ratios: E ciency
Contents
Introduction 1
Learning Objectives 2
Quick Look 3
Case Study 16
Keep in Mind 17
Try This 18
Challenge Yourself 21
Photo Credits 22
Bibliography 22
Appendix 23
Statement of Comprehensive Income and Financial Position 23
Lesson 2.4
Introduction
By now, you have already learned that it is vital for businesses to generate profit. Similar to
the importance of blood in the human body, profit is essential to keep the business alive.
Without it, the business stops operating, which could then lead to closure. Companies,
regardless of size, need profits for their operations to continue. Thus, financial management
takes a crucial role in attaining this goal.
Good financial management results in profitability1 and wealth maximization. One aspect to
consider when aiming for profitability is the efficient use of the firm’s resources. A business
is said to be efficient when it is able to produce products at a minimum cost, without
wasting resources or assets, and still generates profit. In some instances, firms prefer to
adopt technological advancement to improve business efficiency, increase productivity, and
gain a competitive advantage in their field.
1
profitability (noun) - This refers to the ability to generate income.
Companies also hire financial managers to identify the most effective way to utilize their
resources without compensating much of their earnings. Most of the time, financial
managers use financial ratios to analyze and evaluate business efficiency. In this learning
material, you will be able to solve, analyze, and interpret financial ratios that aid financial
managers to create sound decisions in terms of business efficiency.
At the end of this lesson, you should be able to Define the measurement levels, namely,
liquidity, solvency, stability, and profitability
do the following:
(ABM_BF12-IIIb-7).
● Explain the definition, uses, and
limitations of efficiency ratios.
● Enumerate the common efficiency ratios
used by businesses.
● Perform financial ratio analysis using the
efficiency ratios.
● Interpret the efficiency ratios as applied
in a simple business case.
Quick Look
Resource Efficiency
In economics, you have learned that there are limited resources available in an environment
that you must properly allocate and manage to produce goods and services for people’s
satisfaction. The utilization and maximization of these resources is a challenge for those
who aim for efficiency.
Questions to Ponder
1. What do you think is the most important business resource or asset of value? Explain
your answer.
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2. What could possibly happen if a business does not seek efficiency?
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Cash2 is considered the most liquid asset of any business. It is also considered the most
important financial resource because it is readily available for use. Without cash, a business
cannot fully operate. Hence, other assets like accounts receivable3 and inventories4 must be
converted into cash to maximize the use of resources. Additionally, the adequacy of working
capital5 must also be considered in evaluating business efficiency.
Essential Question
Efficiency Ratios
An efficiency ratio is a financial ratio used that measures the ability of a business to utilize
its assets to generate profit (Kenton 2021). Typically, a company’s management team uses
financial ratio6 to analyze and evaluate the company’s performance in terms of its
management activities. These management activities include the utilization and
maximization of assets such as accounts receivables, inventories, and fixed assets7. Thus,
efficiency ratio is also referred to as an activity ratio or management ratio. Firms with good
management ratios efficiently use their resources at low cost while keeping their net income
high (Cabrera 2015, 225).
2
cash (noun) - These are bills and coins owned by the business.
3
accounts receivable (noun) - This refers to the claim of payment from another party.
4
inventory (noun) - These are goods held for sale.
5
working capital (noun) - This is the difference between current assets and current liabilities.
6
financial ratio (noun) - This is the numerical value one gets from comparing accounting items from financial statements.
7
fixed assets (noun)- These are tangible assets that companies hold on a long-term basis.
profit (Cabrera 2015, 225). Specifically, efficiency ratios are used to evaluate the
credit-collection policies, the management of buying and selling inventories, the efficiency of
the company in meeting its obligations, the activities involved in maintaining working capital,
and the utilization of long-term or fixed assets to meet its operating requirements.
Figure 1. Efficient collection of receivables is crucial in ensuring that there is enough cash to buy
inventories and pay obligations.
Although efficiency ratios are used to measure a firm’s performance in terms of utilization of
its assets, there are also limitations that must be considered, such as the following (Cabrera
2015, 224):
1. There is a lack of consistency in the application of accounting principles and
standards. While there are generally accepted accounting principles, the use of these
principles and standards still vary depending on the business industry.
2. Comparison of efficiency ratios is only useful when comparing similar businesses in
the same industry.
3. Efficiency ratios are not absolute measures in all areas of a company’s management
performance. These ratios only indicate the level of efficiency of asset management.
Closer Look
To get the accounts receivable turnover ratio, we must take the two balances of
accounts receivable (the beginning and ending balance) and compute the average
balance. The beginning balance of an account is the ending balance of the previous
period. Since we are trying to solve the accounts receivable turnover ratio for 2020,
the beginning balance of accounts receivable is the year-end balance in 2019.
Hence, in this case, the beginning balance is ₱150,000, and the ending balance is
₱130,000.
365 𝑑𝑎𝑦𝑠
average collection period =
𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Although the accounts receivable turnover ratio is the only unknown, we might as
well solve for the average collection period to determine how many days the
company takes to collect the receivables from their customers.
365 𝑑𝑎𝑦𝑠
average collection period =
𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
365 𝑑𝑎𝑦𝑠
=
3.21
average collection period = 113.56 or 114 days
When we are talking about days, it should be converted into a whole number. In this
case, the 113.56 days must be rounded up to 114 days.
365 𝑑𝑎𝑦𝑠
average sale period =
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
Similar to the accounts receivable turnover ratio, it is best to solve for the average
sale period to determine how many days it did take for a company to sell its
inventories in a year.
365 𝑑𝑎𝑦𝑠
average sale period =
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
365 𝑑𝑎𝑦𝑠
=
9.83
average sale period = 37.13 or 37 days
Since we are talking about days, we should still get the whole number of the average
sale period. But unlike in the average collection period, 37.13 was rounded down to
37 days.
In general, the higher the inventory turnover ratio, the better it is for a business. It
only implies that a business is able to generate more income because it is able to
sell at a fast rate. When the inventory turnover is low, this indicates that there are
fewer sales. The ideal inventory turnover ratio depends on the nature of a business.
The net book value (NBV) means that the depreciation was already taken into
account and that it has already been deducted from the building’s cost.
= 5.43 times
Step 5: Interpret your answer.
Benny Enterprise’s fixed asset turnover ratio is 5.43 times. This means that the
business efficiently used its fixed assets to create outputs 5.43 times in a year.
= 1.38 times
When the total assets turnover ratio is low relative to its industry, it may imply that a
firm is heavily invested in different assets but did not maximize the use of these
resources because it did not improve or increase its sales.
= 3.21 times
Step 5: Interpret your answer.
The working capital turnover ratio of Benny Enterprise is 3.21 times. This
implies that the working capital is being recirculated 3.21 times in a year to
generate more income.
Case Study
What do these financial ratios imply? The results suggested that the firm
should evaluate its credit-collection policies, especially since it takes them
two months to convert receivables into cash. Also, it was recommended
that they monitor their sales since the inventory turnover is higher than
the firms in the same industries, resulting in a net loss for the company.
Keep in Mind
● Efficiency is vital in ensuring profit and wealth maximization. Efficiency ratios are
used to measure the ability of a business to maximize the use of its assets and
generate profit. These ratios are also known as activity ratios or management ratios.
● The different efficiency ratios are as follows:
● Accounts receivable turnover ratio measures how many times a company is able to
collect cash from its receivables in a year. It is also best to compute the average
collection period to determine the days a company spends collecting these
receivables.
● The inventory turnover ratio measures how many times a firm buys and sells its
inventories in a year. The average sale period also determines how many days a firm
can sell its inventories.
● The fixed asset turnover ratio assesses a management’s efficiency in generating
sales using its fixed assets, while the total asset turnover ratio assesses the
efficiency of a management in generating sales using all its assets.
● The working capital turnover ratio measures the adequacy and activity of the
working capital.
Try This
________________ 2. What do you call the difference between current assets and
current liabilities?
________________ 4. What are the goods held by the business for sale?
B. True or False. Write true if the statement is correct. Otherwise, write false.
1. If you were to become a financial manager someday, how would you ensure the
resource efficiency of the company you will be working in to guarantee that wealth
maximization is also achieved?
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2. ABC Enterprise is a new firm in the food and beverage industry. The owner of this
firm tasked you to be the financial manager and look for the average efficiency ratios
of the industry. Do you think that there are benefits of using financial-ratio analysis
as a tool for benchmarking? If yes, what could be these benefits?
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3. Based on these efficiency ratios, do you think that FED Bookstore is efficient
concerning its credit collection? Why so?
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4. How long does it take for FED Bookstore to sell its books? Based on this, do you think
that the firm is efficient as to its inventory turnover? Explain your answer.
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5. Considering the total asset turnover ratio, are there any problems encountered by
the firm in terms of the utilization of its assets to obtain income? What might be
these problems?
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Challenge Yourself
1. How will you educate a grocery-store owner about the importance of inventory
turnover ratio in his/her business?
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2. How can you apply the accounts receivable turnover ratio in your life as an
individual? You may cite your own experiences.
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Photo Credits
Productivity, by geralt is free to use under the Pixabay license via Pixabay.com.
Invoice cash payment, by Mohamed Hassan is free to use under the Pixabay license via
Pixabay.com.
Bibliography
Cabrera, Ma. Elenita B. Financial Management: Principles and Applications. Manila, Philippines:
GIC Enterprises & Co., Inc., 2015.
Henry W. Collier, et. al. “An Example of Financial Ratio Analysis.” Journal of Business Case
Studies 6, no. 4 (July/August 2010).
https://clutejournals.com/index.php/JBCS/article/download/887/871/3499.
Kenton, Will. Investopedia. “Efficiency Ratio Definition.” Last modified on May 7, 2021.
https://www.investopedia.com/terms/e/efficiencyratio.asp.
Appendix
Statement of Comprehensive Income and Financial Position
Benny Enterprise
Statement of Comprehensive Income
For the Years Ended December 31, 2019 and 2020
2019 2020
Net Sales 500,000.00 450,000.00
Less: Cost of Goods Sold 316,000.00 230,000.00
Gross Profit ₱ 184,000.00 220,000.00
Less: Operating Expense
Selling Expenses 64,000.00 43,000.00
Administrative Expenses 10,000.00 17,000.00
Net Income ₱ 110,000.00 160,000.00
Benny Enterprise
Statement of Financial Position
As of December 31, 2019 and 2020
Noncurrent Assets
Land ₱ 50,000.00 40,000.00
Building, net 37,400.00 38,200.00
Intangible Assets 15,000.00 14,000.00
102,400.00 92,200.00
Current Liabilities
Accounts Payable ₱ 35,000.00 40,000.00
Notes Payable 12,700.00 21,900.00
Wages Payable 20,000.00 18,000.00
Rent Payable 15,000.00 15,000.00
82,700.00 94,900.00
Noncurrent Liabilities
Long-term notes payable 16,300.00 11,100.00
Owner’s equity
Benny, Capital 242,400.00 205,200.00