How to use efficiency ratios when buying stocks
Efficiency ratios measure how well a company uses its assets and manages its liabilities. Common efficiency ratios include inventory turnover, accounts receivable turnover, accounts payable turnover and total asset turnover.
When buying stocks you should look for companies that are the most effective at managing their assets and have good fundamentals which will translate into potential higher future returns for the shareholders. If a company is not running efficiently it is not attractive to investors because they are not making the best use of the shareholders’ capital to generate additional profits for them.
Efficient companies are able to:
- turn inventory quickly yet never have inventory shortages
- quickly collect payments from their credit customers
- have advantageous payment terms with their suppliers
When using efficiency ratios to evaluate companies you should also compare the values against companies operating within the same industry and also analyze the past performance to see the trend.
The inventory turnover, which measures how efficient a company is at managing its inventory level, is calculated by dividing the company’s Cost of goods sold by the Average Inventory.
Inventory turnover = Cost of goods sold / Average Inventory
In general, the higher the number of times inventory turns over in a year the better since a low ratio indicates that the company might be overstocking or having a difficult time selling its products (recall that inventory ties up capital).
The accounts receivable turnover, which measures how quickly the company is at collecting payments from its credit customers, is calculated by dividing the company’s revenue by the average accounts receivable.
Accounts receivable turnover = Revenue / Average Accounts receivable
The higher the ratio, the quicker the company is at collecting the payment from the customer. If the ratio is too low it is a red flag because it might indicate that the company is having difficulties collecting the payments and/or is granting credit to its customers too generously.
The accounts payable turnover, which measures how efficient a company is at paying its own bills (the more delayed the payments are the better), is calculated by dividing the cost of goods sold by the average accounts payable.
Accounts payable turnover = Cost of goods sold / Average Accounts payable
As an investor you want this number to be as low as possible. A high accounts payable turnover ratio indicates that the company is not receiving favorable payment terms from its suppliers.
The total asset turnover, which measures how efficiently the company is using its overall assets, is calculated by dividing the company’s Revenue by the Average total assets.
Total asset turnover = Revenue / Average Total assets
Using efficiency ratios in combination with other financial ratios such as profitability ratios, leverage ratios, and liquidity ratios will provide you will a more complete view of the financial health of a company.