An efficiency ratio, also known as a labor ratio, shows a company's performance by comparing the company's operating cost with the profit made. A rough estimate of the efficiency ratio is determined by dividing the company's expenses by its revenues or profits. This number is converted to a percentage and the lower the percentage, the better the business is doing. The efficiency ratio gives a company an idea of how much money it spends to earn a dollar of revenue. A ratio that shows you spend more than a dollar for every dollar you earn means the company is losing money and needs to change its methods to cut costs.
For example, a small business might earn $10,000 US Dollars (USD) in a year and spend $5,000 Dollars that year to produce its products. To calculate your efficiency ratio, you would divide expenses by profit, taking 5,000 and dividing by 10,000 to get a 0.5 or 50% answer. This tells the company that it spent half of what it earned on production and that it must spend half a dollar to earn a full dollar. Therefore, the business has an efficiency ratio of 50%. The company can then see if it can reduce that number and find ways to ensure it doesn't increase. An efficiency rating of 100% or more indicates loss, not gain.
When calculating this ratio, the company considers its overhead, a term that covers the company's annual operating expenses. Certain factors, such as income tax, are not considered in general expenses. This allows the company to consider only the money it actually has to spend on production and not the money spent directly or indirectly for other purposes.
There are several types of efficiency indices. Each type targets a different aspect of the business to gauge how well you are doing financially. The different efficiency ratios include inventory turnover, accounts receivable turnover, accounts payable turnover and total asset turnover. The accounts receivable turnover ratio would show the company whether or not it is in good standing by comparing the amount of credit issued versus the amount borrowers pay. The other types of efficiency ratios perform similar tasks but focus on different areas, ranging from specific income information to ratios that show how long it takes to make money from a credit sale.