Lesson 50 - Beginner accounting course

50. Efficiency Ratios: Inventory Turnover and Accounts Receivable Turnover

Efficiency ratios measure how effectively a company manages its assets and liabilities to generate revenue. These ratios help businesses understand how quickly they convert inventory into sales and how efficiently they collect payments from customers.

Two key efficiency ratios are:

1. Inventory Turnover Ratio – Measures how fast a company sells its inventory.

2. Accounts Receivable Turnover Ratio – Indicates how efficiently a company collects payments from customers.

Both ratios provide insights into operational performance and cash flow management.

1. Inventory Turnover Ratio: Formula and Interpretation

The Inventory Turnover Ratio shows how many times a company sells and replaces its inventory within a given period. A high turnover rate generally means strong sales and efficient inventory management, while a low turnover rate may indicate overstocking or weak demand.

Formula:

Where:

• COGS = The direct cost of producing goods sold during the period.

• Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2

Interpretation:

• A high inventory turnover (above industry average) suggests strong sales or efficient inventory management.

• A low inventory turnover may indicate slow-moving inventory, excessive stock, or declining demand.

• Ideal range: Varies by industry. Grocery stores typically have higher turnover rates than luxury goods retailers.

Example:

• Company A sells and restocks its inventory 5 times per year, indicating efficient operations.

• Company B has a lower turnover, which may suggest overstocking or weak sales.

2. Accounts Receivable Turnover Ratio: Formula and Interpretation

The Accounts Receivable Turnover Ratio measures how efficiently a company collects payments from customers. A high turnover means customers are paying quickly, while a low turnover may indicate collection issues or lenient credit policies.

Formula:

Where:

• Net Credit Sales = Total sales made on credit (excluding cash sales).

• Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) ÷ 2

Interpretation:

• A high ratio (above industry average) suggests the company collects payments efficiently.

• A low ratio may indicate late payments, poor credit policies, or bad debts.

• Ideal range: Higher is better, but too high may mean the company is too strict with credit, potentially losing sales.

Example:

Company A collects receivables 6 times per year, meaning it has efficient credit policies.

Company B has a lower turnover, which may indicate slow collections or lenient credit terms.

3. Why Are Efficiency Ratios Important?

• For Business Owners: Helps optimize inventory management and credit policies.

• For Investors: Indicates how well a company manages resources to generate sales.

• For Creditors: Shows the company’s ability to generate cash flow and meet financial obligations.

Companies with strong efficiency ratios tend to have better cash flow, lower risk of financial distress, and higher profitability.