What They Measure
The portion of operating revenues or fee income spent on overhead expenses.
Why They Are Important
Often identified with banking and financial sectors, the efficiency ratio indicates a management’s ability to keep overhead costs low. This measurement is also used by mature industries, such as steel manufacture, chemicals, or auto production, that must focus on tight cost controls to boost profitability because growth prospects are generally modest.
In some industries, the efficiency ratio is called the overhead burden, which is overheads as a percentage of sales.
A different method measures efficiency simply by tracking three other measures: accounts payable to sales, days sales outstanding, and inventory turnover, which indicates how fast a company is able to move its merchandise. A general guide is that if the first two of these measures are low and third is high, efficiency is probably high; the reverse is likewise true.
How They Work in Practice
The efficiency ratio is defined as operating overhead expenses divided by fee income plus tax equivalent net interest income. If operating expenses are $100,000, and revenues (as defined) are $230,000, then:
Efficiency ratio = 100,000 ÷ 230,000 = 0.43
However, not everyone calculates the ratio in the same way. Some institutions include all noninterest expenses, while others exclude certain charges and intangible asset amortization.
To find the inventory turnover ratio, divide total sales by total inventory. If net sales are $300,000 and inventory is $100,000, then:
Inventory turnover ratio = 300,000 ÷ 140,000 = 2.14
To find the accounts payable to sales ratio, divide a company’s accounts payable by its annual net sales. A high ratio suggests that a company is using its suppliers’ funds as a source of cheap financing because it is not operating efficiently enough to generate its own funds. If accounts payable are $42,000 and total sales are $300,000, then:
Accounts payable/sales ratio = 42,000 ÷ 300,000 = 0.14 = 14%
Tricks of the Trade
Identifying “overheads” to calculate the efficiency ratio can itself contribute to overall inefficiency. Some financial experts contend that efficiency can be measured equally well by reviewing earnings per share growth and return on equity.
Some banks identify amortization of goodwill expense, and pull it out of their noninterest expense in order to calculate what is called the cash efficiency ratio: noninterest expense minus goodwill amortization expense divided into revenue.
In banking, an acceptable efficiency ratio was once in the low 60s. Now the goal is 50, while better-performing banks boast ratios in the mid 40s. Low ratings usually indicate a higher return on equity and earnings.