Title: The Efficiency Ratio — What It Measures, How to Calculate It, and Practical Steps to Improve It
Introduction
The efficiency ratio is a family of metrics that measure how effectively a business uses assets, liabilities and operating resources to generate revenue. These ratios—also called activity ratios—are especially useful for evaluating short-term operating performance, identifying management strengths or weaknesses, and comparing companies within the same industry. In banking, the term has a specific, widely used meaning: non-interest expenses divided by revenue.
Key takeaways
– Efficiency ratios quantify how well a company uses working capital, fixed assets and staff to generate sales or revenue.
– Common forms include accounts receivable turnover, inventory turnover, asset turnover and, for banks, the bank efficiency ratio (non‑interest expenses ÷ revenue).
– For banks, a lower efficiency ratio is better; many analysts consider about 50% or less to be optimal, though acceptable ranges vary by business model and market conditions.
– Use efficiency ratios alongside profitability and growth metrics and adjust for one-time events, seasonality and industry differences.
What is the efficiency ratio?
At its core, an efficiency ratio is any ratio that expresses operating effectiveness: how quickly receivables convert into cash, how often inventory turns, or how many dollars of revenue each dollar of assets supports. Improvements in these ratios often translate into improved profitability and cash flow.
Common efficiency ratios and formulas
Below are frequently used efficiency/activity ratios and how to calculate them:
– Accounts Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable
– Days Sales Outstanding (DSO) = 365 ÷ Accounts Receivable Turnover
– Inventory Turnover = Cost of Goods Sold (COGS) ÷ Average Inventory
– Days Inventory Outstanding (DIO) = 365 ÷ Inventory Turnover
– Accounts Payable Turnover = Purchases (or COGS if purchases not available) ÷ Average Accounts Payable
– Days Payables Outstanding (DPO) = 365 ÷ Accounts Payable Turnover
– Asset Turnover = Net Sales ÷ Average Total Assets
– Fixed Asset Turnover = Net Sales ÷ Average Net Fixed Assets
– Working Capital Turnover = Net Sales ÷ Average Net Working Capital
How the efficiency ratio is defined for banks
In banking, the efficiency ratio has a narrow definition:
Bank Efficiency Ratio = Non‑interest Expenses ÷ Revenue
(Revenue usually excludes interest expense/net interest income adjustments as reported by the bank; some analysts use total revenue as reported.)
Interpretation:
– A lower ratio means the bank spends less to generate each dollar of revenue—i.e., it operates more efficiently.
– An increasing ratio indicates expenses are rising faster than revenue (or revenue is falling), which can signal deteriorating operating efficiency.
– Benchmarks: Many banks aim for an efficiency ratio around or below 50%; community and regional banks often have higher ratios; investment banks and large-scale digital banks may exhibit different ranges.
Example calculations (practical)
1) Bank example:
– Quarterly non‑interest expenses = $400 million
– Quarterly revenue (non‑interest + fee income + other non‑interest revenue) = $700 million
Efficiency Ratio = 400 ÷ 700 = 0.571 → 57.1%
Interpretation: The bank spends $0.57 to generate each dollar of revenue. If last year’s ratio was 63.2%, the bank improved operating efficiency.
2) Accounts Receivable turnover example:
– Annual net credit sales = $12,000,000
– Beginning AR = $900,000; ending AR = $1,100,000 → Average AR = $1,000,000
AR Turnover = 12,000,000 ÷ 1,000,000 = 12
DSO = 365 ÷ 12 ≈ 30.4 days
How analysts use efficiency ratios
– Trend analysis: track ratios over multiple periods to identify improving or worsening operational performance.
– Peer comparison: compare companies operating in the same industry and similar business models to spot relative strengths/weaknesses.
– Complementary insight: combine with margin, ROA/ROE, liquidity and growth metrics to form a comprehensive view.
– Risk & credit analysis (for banks): an improving efficiency ratio can support stronger earnings capacity; deteriorating ratios may flag expense control or revenue problems.
Practical steps to calculate and monitor efficiency ratios
1. Choose the right ratio(s) for your business model (banks vs. manufacturing vs. retail).
2. Standardize inputs:
– Use consistent definitions (e.g., what constitutes revenue, whether to use net sales or include other items).
– Use averages for balances (beginning + ending ÷ 2) where appropriate.
3. Calculate on the same basis across periods (quarterly, trailing 12 months) to smooth seasonality.
4. Benchmark against peers and industry medians.
5. Adjust for one-time items (restructures, large asset sales, litigation) so one-off effects don’t distort trend analysis.
6. Report both the ratio and the underlying drivers (expense growth rate, revenue growth rate, asset levels).
Practical steps to improve efficiency ratios (actionable measures)
For banks:
1. Reduce non‑interest costs:
– Streamline back‑office operations and automate processes.
– Consolidate branches where digital channels suffice.
– Outsource noncore functions selectively.
2. Increase revenue without proportionally increasing costs:
– Grow fee-based income (payments, asset management, advisory).
– Cross-sell higher‑margin products to existing customers.
3. Invest in digital channels:
– Improve online onboarding, mobile banking and digital servicing to lower per‑customer operating cost.
4. Rationalize staff and technology spending carefully to avoid harming service quality or future growth.
For non‑bank businesses:
1. Shorten cash conversion cycle:
– Tighten credit terms and collections processes.
– Offer discounts for early payment or use electronic invoicing.
2. Improve inventory management:
– Adopt just‑in‑time, demand forecasting and better supplier collaboration.
– Reduce obsolete stock with SKU rationalization.
3. Raise asset utilization:
– Optimize production scheduling, increase machine uptime and outsource low‑utilization assets.
4. Control operating expenses:
– Review fixed vs. variable cost structure.
– Automate routine tasks and renegotiate supplier contracts.
5. Consider pricing and product mix:
– Increase prices where elasticity allows.
– Favor higher‑margin products and services.
Monitoring, reporting and governance
– Track efficiency ratios in monthly/quarterly dashboards alongside revenue growth and margin metrics.
– Set targets by business line (retail banking, corporate banking, product lines) rather than one company‑wide target alone.
– Escalate persistent negative trends for management action; investigate root causes (cost creep, product margin decline, competitive pressure).
– Use rolling 12‑month measures to smooth seasonal volatility.
Limitations and caveats
– Industry differences: Overly simple comparisons across industries are misleading—asset‑heavy manufacturers will have different norms than service firms or banks.
– Accounting variation: Different companies may classify expenses or revenues differently; reconciling line items may be necessary.
– Short‑term vs. long‑term tradeoffs: Cost cuts can improve short‑term efficiency but harm long‑term competitiveness or growth.
– One-off events and seasonality: Large one-time expenses or seasonal revenue swings can distort the ratio unless adjusted.
– For banks: the exclusion of interest income/expense from the numerator or denominator depends on the chosen definition—confirm the exact accounting basis used by the bank.
The bottom line
Efficiency ratios are vital tools for understanding how effectively a company turns assets and operations into revenue. For non‑bank companies, a set of activity ratios (receivable turnover, inventory turnover, asset turnover) reveals operational strengths and weaknesses. For banks, the widely used efficiency ratio (non‑interest expenses ÷ revenue) directly measures overhead control. Use these ratios alongside profitability and growth metrics, standardize calculations, benchmark peers, and apply practical operational improvements that balance efficiency with long‑term strategy.
Source
This article is based on principles and definitions from Investopedia: “Efficiency Ratio.” (Source: https://www.investopedia.com/terms/e/efficiencyratio.asp)
Continuation — Expanded Guide to the Efficiency Ratio
Source: Investopedia — What Is the Efficiency Ratio? (https://www.investopedia.com/terms/e/efficiencyratio.asp)
Additional sections, examples, practical steps, interpretation guidance, limitations, and a concluding summary follow.
OVERVIEW RECAP
The efficiency ratio (also called an activity ratio in corporate finance, and often the cost‑to‑income ratio in banking) measures how well a firm uses resources to generate revenue. In general corporate settings it examines turnover of assets and liabilities (receivables, inventory, fixed assets); in banking it is most commonly expressed as non‑interest (operating) expenses divided by revenue (net interest income + non‑interest income). Lower ratios indicate greater efficiency.
PRACTICAL STEPS TO CALCULATE THE EFFICIENCY RATIO
Step 1 — Decide the variant you need
– Banking variant: efficiency ratio = non‑interest (operating) expenses ÷ total revenue (usually net interest income + non‑interest income).
– Corporate/activity variant: choose a specific turnover ratio (e.g., accounts receivable turnover, inventory turnover, fixed asset turnover) that matches the operational question you want to answer.
Step 2 — Pull the correct line items from financial statements
– For banks: use the income statement lines for non‑interest expenses (salaries, rent, tech, provisioned operating costs) and revenue components (net interest income and non‑interest income such as fees).
– For corporate ratios: use net sales or revenue and the average balance of the relevant asset (e.g., average receivables = (beginning AR + ending AR)/2).
Step 3 — Use a consistent period and peer set
– Calculate on the same periodic basis (quarterly/yearly) and compare to peers and historical trends.
Step 4 — Compute, analyze trend and context
– Calculate the ratio, compare it to prior periods and industry peers, and investigate drivers (revenue growth, cost control, one‑off items).
COMMON FORMULAS (PICK THE RIGHT ONE)
– Bank efficiency ratio (common definition):
Efficiency ratio = Non‑interest expenses / (Net interest income + Non‑interest income)
– Accounts receivable turnover:
AR turnover = Net credit sales / Average accounts receivable
Days sales outstanding (DSO) = 365 / AR turnover
– Inventory turnover:
Inventory turnover = Cost of goods sold / Average inventory
Days inventory outstanding (DIO) = 365 / Inventory turnover
– Fixed asset turnover:
Fixed asset turnover = Net sales / Average net fixed assets
EXAMPLE CALCULATIONS
Bank example (typical)
– Bank A:
– Non‑interest (operating) expenses = $600 million
– Net interest income = $1,200 million
– Non‑interest income (fees, trading) = $300 million
– Revenue = 1,200 + 300 = $1,500 million
– Efficiency ratio = 600 / 1,500 = 0.40 = 40%
Interpretation: 40% is generally strong (lower means better). Many banks target <50% as an efficient benchmark, though acceptable levels vary by business model and market.
Bank example showing deterioration
– Same bank last year:
– Expenses = $700M; revenue = $1,400M → efficiency = 700/1,400 = 50%
– Change: efficiency improved from 50% to 40%. Improvement could be due to cost cuts or revenue growth.
Corporate example — Accounts receivable turnover
– Company B:
– Net credit sales = $18,250,000
– Beginning AR = $1,500,000; ending AR = $2,000,000 → average AR = $1,750,000
– AR turnover = 18,250,000 / 1,750,000 = 10.43 turns
– DSO = 365 / 10.43 ≈ 35 days
Interpretation: On average Company B collects receivables in ~35 days. Compare with industry norms to judge efficiency.
Corporate example — Inventory turnover
– Company C:
– COGS = $9,000,000
– Beginning inventory = $1,200,000; ending inventory = $800,000 → avg inventory = $1,000,000
– Inventory turnover = 9,000,000 / 1,000,000 = 9 turns
– DIO = 365 / 9 ≈ 41 days
Interpretation: Inventory converts to sales about every 41 days; whether that’s good depends on the sector (fast‑moving consumer goods vs. capital equipment differ widely).
INTERPRETATION GUIDELINES
– Lower is better for the bank cost‑to‑income efficiency ratio (shows expenses are low relative to income).
– Higher turnover (receivables, inventory, fixed assets) generally indicates better utilization; lower turnovers suggest sluggish conversion of assets into revenue.
– Always compare:
– To historical trends for the same company.
– To peer group and industry medians (industry norms vary widely).
– Investigate what’s driving changes:
– Revenue growth without a proportional rise in expenses improves the ratio.
– One‑time gains, accounting changes, or cyclical revenue swings can distort short‑term readings.
HOW ANALYSTS USE EFFICIENCY RATIOS
– Screening: spot companies or banks that are well managed relative to peers.
– Trend analysis: evaluate whether efficiency is improving as management executes cost reduction or growth strategies.
– Profitability drivers: link efficiency ratio improvements to margins and return on equity.
– Valuation inputs: efficiency affects sustainable earnings and potential margins used in models.
– Operational due diligence: identify bottlenecks (slow receivables, excess inventory) that can be remedied.
HOW MANAGEMENT CAN IMPROVE EFFICIENCY RATIOS — PRACTICAL STEPS
For banks:
– Automate back‑office processes to cut operating costs.
– Reprice products or increase fee income to boost non‑interest revenue.
– Optimize branch footprint and staffing models.
– Outsource noncore functions where cost‑effective.
For corporates:
– Tighten credit policies and collections to improve AR turnover.
– Implement just‑in‑time and supplier negotiation strategies to lower inventory days.
– Invest in productivity enhancing equipment to improve fixed asset turnover.
– Reduce overhead and streamline processes with technology.
LIMITATIONS & PITFALLS
– One‑off items: restructuring costs, litigation settlements, or one‑time gains can skew the ratio.
– Accounting differences: capital vs. operating leases, revenue recognition and expense classification can make cross‑company comparisons misleading.
– Business mix matters: a fee‑heavy bank or investment bank will have different normative ratios than a regional commercial bank.
– Over‑optimization risk: cutting essential investment or compliance spending to “improve” the ratio can harm long‑term performance.
INDUSTRY BENCHMARKS (RULES OF THUMB)
– Banking: many efficient banks target efficiency ratios below 50%; elite banks or high‑productivity intermediaries can be significantly below that. Regional averages vary.
– Retail/consumer goods: high inventory turns and lower DSO are common; benchmarks differ widely between grocery, apparel, and durable goods.
– Manufacturing and heavy industry: lower fixed‑asset turnover and higher inventory days are normal relative to service industries.
EXAMPLE SENSITIVITY: HOW CHANGES AFFECT THE RATIO
– Example: Bank B with expenses $400M, revenue $1,000M → efficiency = 40%
– If expenses rise 10% to $440M while revenue stays flat, efficiency = 44% → deterioration.
– If revenue grows 10% to $1,100M while expenses unchanged, efficiency = 400/1,100 ≈ 36.4% → improvement.
REPORTING & MONITORING RECOMMENDATIONS
– Report efficiency ratios quarterly and on a trailing‑12‑month (TTM) basis to smooth seasonality.
– Reconcile and footnote one‑time items so trends reflect underlying operations.
– Combine ratio analysis with margin, ROA, ROE and growth metrics for a holistic view.
CONCLUSION — KEY TAKEAWAYS
– The efficiency ratio is a versatile measure of how effectively an organization converts resources into revenue. In banking it is typically non‑interest (operating) expenses divided by revenue (net interest income + non‑interest income); for corporates it manifests as various turnover ratios (receivables, inventory, fixed assets).
– Lower bank efficiency ratios and higher asset turnover ratios generally signal better operational performance, but interpretation requires context: industry norms, business model, and one‑off items.
– Practical use requires consistent calculation, peer benchmarking, trend analysis, and attention to drivers. Management can improve ratios by cutting unnecessary costs, increasing revenue, and optimizing asset use — but should avoid short‑term cuts that damage long‑term capacity.
– Always combine efficiency ratios with other financial and operational metrics to get a complete picture of business health.
References
– Investopedia: What Is the Efficiency Ratio? https://www.investopedia.com/terms/e/efficiencyratio.asp
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