IS YOUR COMPANY FINANCIALLY EFFICIENT?
Most companies and organizations compete for a finite amount of customers and their dollars.
Even nonprofit organizations have a limited amount of money they receive from donations and grants. To compete at optimal performance for the limited consumer dollars, financially efficient companies maximize their profits with a limited asset base, which creates a competitive advantage for themselves over their competitors.
Financial efficiency is the ability of the company to generate sales through its assets. As such, companies that are more financially efficient generate more sales through their asset base. To measure financial efficiency the business owner must calculate turnover ratios relating sales and cost of goods sold to their respective assets. Companies that report higher turnover ratios are more financially efficient at using their assets.
The four ratios that creditors and investors monitor to determine a company’s financial efficiency are:
1. Net Sales to Assets
2. Net Sales to Fixed Assets
3. Net Sales to Accounts Receivable
4. Cost of Goods Sold to Inventory
Net Sales to Assets Calculated by dividing net sales by total assets (Net Sales/Total Assets), this ratio tends to remain very stable except during a sales-growth period or salesdecline period. The instability for this ratio during sales growth/ decline occurs for two reasons. Net sales represent a company’s sales after accounting for returns or bad debt that was not collected for original purchase during the sale.
The first reason for instability occurs due to a change in current assets (any asset that can convert to cash in a year or less) resulting from large changes in sales. For example, an increase in sales might increase cash or accounts receivable, both of which the balance sheet classifies as current assets.
The second reason for instability arises from fixed-assets expenditures (the payment or disbursement to purchase a fixed asset) leading or lagging sales. If sales grow or shrink at a faster or slower pace than purchasing fixed assets, this ratio becomes unstable.
A higher ratio is better. Companies able to keep this ratio high (especially over their competitors) require fewer assets to generate more sales and usually enjoy more profitability as a result.
Net Sales to Net Fixed Assets Net fixed assets are simply the fixed assets on the balance sheet (real estate, equipment, automobiles, etc.) after applying the accumulated depreciation (i.e., gross fixed assets minus accumulated depreciation). Net fixed assets take the purchase price or market value of the asset and recognize the wear and tear and any obsolescence over the life of the asset.
To calculate this ratio, divide Net Sales by net fixed assets (Net Sales/Net Fixed Assets). This ratio proves beneficial for companies relying heavily on net fixed assets to generate sales. For example, a real estate holding company that owns several properties and collects rent.
A higher ratio demonstrates the company uses the fixed assets to achieve higher sales. A word of caution, though, as a high ratio might also signal that the company is operating with an inadequate plant or equipment, which would require a large expenditure to keep up with competitors. A low, or declining, ratio might indicate assets that are not contributing to sales.
Net Sales to Accounts Receivable To calculate this ratio, divide net sales by accounts receivable (Net Sales/Accounts Receivable). Companies with a high ratio demonstrate their ability to outperform competitors with a low ratio because they collect cash from credit customers at a faster pace. Seasonality might contribute to a misleading ratio. Eliminating seasonality from this ratio requires dividing net sales by the monthly or quarterly average of accounts receivable.
Cost of Goods Sold to Inventory The formula for this ratio is dividing cost of goods sold (COGS) by inventory (COGS/Inventory). Companies that report a high level of inventory benefit most by keeping track of this ratio’s performance. The higher the ratio, the less time cash is spent tied up in inventory versus a company with a low ratio. An increase in this ratio usually occurs on the back of strong sales growth as the company struggles to keep inventory levels high enough for demand. Like net sales to accounts receivable, seasonality affects this ratio, which can also be corrected by using the average of monthly or quarterly inventory levels.
While thousands of financial ratios exist to indicate a company’s performance, these four ratios prove to be the absolute minimum when determining a company’s financial efficiency. With a limited amount of customer dollars available for sales, maintaining financial efficiency by optimizing sales growth with minimal assets allows corporations to create and sustain the competitive advantage that will keep them in business for years to come.
Ryan Thomas manages the loan review department for a local bank. His email address is rthomas@cbofla.com.
