Explore the importance of efficiency ratios such as Asset Turnover ratio, Inventory Turnover ratio, and Day Sales in Inventory, which are key measures of a company's ability to effectively utilize their assets and inventory.
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources.
- Asset Turnover ratio measures a company’s ability to generate sales from assets
Asset Turnover Ratio = Net Sales / Average Total Assets
In the retail sector, an asset turnover ratio of 2.5 or more could be considered good, while a company in the utilities sector is more likely to aim for an asset turnover ratio that’s between 0.25 and 0.5.
Inventory Turnover Ratio measures how many times a company’s inventory is sold and replaced over a given period
Inventory Turnover Ratio = COGS / Average Inventory
A good inventory turnover ratio is between 5 and 10 for most industries, which indicates that you sell and restock your inventory every 1-2 months. This ratio strikes a good balance between having enough inventory on hand and not having to reorder too frequently.
- Days sales in inventory measure the average number of days that a company holds on to inventory before selling it to customers
Days Sales in Inventory = 365 days / Inventory Turnover
Managing inventory levels is vital for most businesses, and it is especially important for retail companies or those selling physical goods. While the inventory turnover ratio is one of the best indicators of a company’s level of efficiency at turning over its inventory and generating sales from that inventory, the days sales of inventory ratio goes a step further by putting that figure into a daily context and providing a more accurate picture of the company’s inventory management and overall efficiency.