Activity and Efficiency Metrics
Activity and efficiency metrics weigh a company's ability to use its resources efficiently. They are sometimes viewed as measure of management effectiveness.
In many companies, important business objectives are sometimes defined and measured in terms of activity and efficiency metrics. Initiatives may be launched specifically to improve inventory turns, for instance, through better inventory management or adopting "just in time" sourcing. Initiatives to sell off expensive assets (such as buildings or land) may be aimed at improving asset turnover, for example.
Analysts will look especially for trends or changes in these metrics from year to year, as indicators of the company's ability to improve financial performance and financial position, or as indicators of specific problems that need management attention
Six of the most commonly used activity and efficiency metrics are illustrated below. The examples use data from the sample income statement and balance sheet, also included below.
For a more complete summary of activity and efficiency metrics, along with working spreadsheet examples integrated with source financial statements and a complete range of other financial metrics, see Financial Metrics Pro.
Seven Activity and Efficiency Metrics
Sales Revenue per Employee
Inventory Turns
Days Sales in Inventory or Average Turnover Period
Accounts Receivable Turnover
Average Collection Period or Days Sales Outstanding
Total Asset Turnover
Fixed Asset Turnover
Sample Income Statement
Sample Balance Sheet
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Seven Activity and Efficiency Metrics
Sales Revenues per Employee
Sales revenues per employee is a simple but informative measure of the company's ability to generate sales revenues with its employee assets. Company publicity may claim that "employees are our most important assets," but employee value does not appear within the structure of the balance sheet. While the balance sheet itself does not measure employee value this way, this metric, sales revenue per employee, does provide a rough measure.
This example uses the following data;
Net sales revenues for the period (year): $32,983,000
Average number of employees for the year: 320
Sales Revenue per Employee
= Net sales revenues / Average number of employees
= $32,983,000 / 320
= $103,072
For companies that are growing rapidly or companies engaged in significant layoffs, the employee count at year end may be quite different from its average value during the year. Companies that engage in seasonal hiring and layoffs may also have an average employee count different from the year-end figure. Where employee numbers change significantly during the year, the average employee count for the year is a better measure of efficiency than the year-end figure. In companies where both sales and the employee counts are highly seasonal, the "Sales per employee" metrics should be evaluated on a quarterly (or monthly) basis as well as an annual basis.
Sales Revenues per Employee Rules of Thumb :
- Sales revenues per employee must exceed the company's cost per employee by some percentage, if the company is to be profitable.
- Year-to-year changes in sales revenues per employee should at least keep pace with inflation and rising costs.
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Inventory Turns
Inventories, like other assets, should be working to produce returns. Inventories, that is, should be bringing in cash. Inventories that sit idle for long time periods are not working efficiently and may not be justifying their presence on the balance sheet. Assets such as construction equipment should be working constantly on construction projects, producing incoming revenues. Similarly, inventory assets "work" by getting off the shelves and turning into sales revenues.
The number of inventory turns per year is a rough measure of inventory liquidity, that is, how easily inventory is turned into cash. Inventoriwa that are not turning into cash are nonproductive assets. Inventory turns are measured by comparing total net sales from the income statement to the value of inventory from the balance sheet. (The balance sheet inventory figures of course represent inventories at period-end. When used this way, the period-end inventory total is viewed as a stand in for the typical or average inventory total for the year, at least for the purpose of creating the inventory turns metric)
The inventory turns example uses these data from the sample financial statements below:
Net sales revenues for the period (year): $32,983,000
Total inventories at period end: $5,986,000
(Note that balance sheet inventory figures may include several asset sub categories, such as raw materials, work in progress, finished goods inventories, office supplies, and others).
Inventory Turns
= Net sales revenues / Total inventories
= $32,983,000 / $5,986,000
= 5.5 turns / year
Inventory Turns Rules of Thumb:
Generally speaking, higher inventory turns are usually preferred over lower inventory turns for several reasons:
- Inventory represents an investment by the company. While the investment sits in inventory, funds used to purchase inventory cannot be used for other purposes.
- Inventory may require expensive storage space and handling.
- Some kinds of inventory lose value quickly: Food, plant, and animal products may be subject to spoilage. Technology products may become outdated and obsolete. Fashion products may have high value only for a short season. Maintaining a high inventory turn rate for products with a short "shelf life" is critical.
On the other hand, inventory turn rates are too high if lack of inventories interferes with the company's ability to maintain manufacturing or production schedules, provide warranty service, expand into new markets, or otherwise meet customer needs.
- In most cases, therefore, the optimal inventory levels and optimal inventory turn rates represent a tradeoff between inventory costs, on the one hand, and the negative business impact of insufficient inventory on the other hand.
- The difference between "good" and "poor" inventory turn metrics varies widely from industry to industry, and even between good companies in the same industry.
- An inventory turn rate that is substantially below industry average may signal a serious problem in production or sales. For a specific company, inventory turns should be compared from year to year, to track changes in efficiency.
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Days Sales in Inventory or Average Turnover Period
The days sales in inventory or average turnover period metric carries the same information as the inventory turns metric (above). Whereas inventory turns is a rate, or frequency per period, the days sales in inventory metric express the same information as a number of days per inventory turn.
Days sales in inventory is calculated by dividing the number of inventory turns per year into the number of days per year. For the same example data used above:
Days sales in inventory
= Days per year / Inventory turns per year
= 365 / 5.5
= 66.4 days
Days Sales in Inventory or Average Turnover Period Rules of Thumb
Since this metric carries the same information as the inventory turns metric (above), see the rules of thumb and guidellnes for inventory turns, above. A minor note of caution when comparing days sales in inventory metrics, however, is to be sure that all values compared are based on the same number of days per year. The metric is sometimes computed with 365 days and sometimes with 360 days.
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Accounts Receivable Turnover
The accounts receivable turnover metric (this section) and average collection period (next section) measure the rate at which accounts receivable turnover. Accounts receivable appear on the balance sheet as assets. Like other assets, those that take longer to turn over are consdiered less less productive than those that turn over quickly.
Accounts receivable turnover is simply the ratio of net sales revenues (an income statement entry) over accounts receivable (a balance sheet item). From the sample financial statements below, the data for the average turnover period metric are:
Net sales revenues: $32,983,000
Net accounts receivable: $1,832,000
Accounts receivable turnover
= Net sales revenues / Net accounts receivable
= $32,983,000 / $1,832,000
= 18.0 accounts receivable turns for the year
Accounts Receivable Turns Rules of Thumb:
- An accounts receivable turns rate greater than 12 indicates that, on average, accounts receivable are collected in one month or less. This conclusion can be drawn about the examle company above, with an accounts receivable ratio of 18.0. If this is in accord with the company's payment terms, the company's collection performance seems healthy.
- The measures of accounts receivable turnover and average collection period (next section) reflect the company's ability to enforce good credit and collection policies. "Normal" or stated collection periods for receivables vary from industry to industry, ranging from 10 to 45 days. When the receivables turnover or average collection period exceeds the company's stated payment policy, this may be a sign that the company is having to accept business from customers who poor credit risks.
- Long collection periods (or low accounts receivable turnover) may also mean the company is having to negotiate extraordinarily long payment terms in order to win business.
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Average Collection Period or Days Sales Outstanding
The average collection period metric (or days sales outstanding) in this section, and the accounts receivable turnover metric (previous section) measure the rate at which accounts receivable turnover. Accounts receivable appear on the balance sheet as assets, but those that take longer to turn over are considered less productive assets than those that turn over quickly.
Average collection calculation begins by finding net sales revenues per day. Using the net sales revenues figure from the sample income statement below ($32,983,000), and a 365 day year,
Net sales revenue per day
= Net sales revenues for the year / Days per year
= $32,983,000 / 365
= $90,364 sales revenues per day
The average collection period is then found by dividing net accounts receivable by the sales revenues per day. Using the net accounts receivable figure from the sample balance sheet below ($1,832,000),
Average collection period
= Net accounts receivable / Net sales revenues per day
= $1,832,000 / $90,364
= 20.3 days
You may notice that the average collection period here (20.3 days), multiplied by the accounts receivable turnover period (18 times/year) results in the figure 365. The average collection period, or days sales outstanding, thus contains the same information as the accounts receivable turnover rate, but just expresses it differently.
Average Collection Period Rules of Thumb.
Because the average collection period carries the same information as the accounts receivable turnover metric (previous section), the two metrics have nearly identical rules of thumb:
- An average collection period less than 30 days indicates that, on average, accounts receivable are collected in one month or less. If this is in accord with the company's payment terms, the company's collection performance seems healthy.
- The measures of accounts receivable turnover (previous section) and average collection period reflect the company's ability to enforce good credit and collection policies. "Normal" or stated collection periods for receivables vary from industry to industry, ranging from 10 to 45 days. When the receivables turnover or average collection period exceeds the company's stated payment policy, this may be a sign that the company is having to accept business from customers who poor credit risks.
- Long collection periods (or low accounts receivable turnover) may also mean the company is having to negotiate extraordinarily long payment terms in order to win business.
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Total Asset Turnover
Companies acquire assets for the purpose of generating revenues. Total asset turnover (this section) and the metric in the next section, fixed asset turnover, compare directly the revenue "returns" from the company's assets (sales revenues) to the book value (balance sheet value) of the assets. The higher the asset turnover rate, the shorter the time required for assets to generate their own value in sales.
These metrics are considered activity, or efficiency metrics. Do not confuse them with profitability metrics, such as return on total assets, or return on equity (those appear in this encyclopedia under profitability metrics).
The total asset turnover metric is a ratio constructed from net sales revenues (an income statement entry) divided by total assets (a balance sheet entry). From the example financial statements below:
Net sales revenues = $32,983,000
Total Assets = $22,075,000
Total asset turnover
= Net sales revenues / Total assets
= $32,983,000 / $22,075,000
= 1.49 total asset turns / year
Total Asset Turnover Rules of Thumb:
- The important information for any company in total asset turnover metrics has to do with year to year changes. Generally, total asset turnover rates should increase from year to year.
- Large investments in assets are necessary in order to operate in some industries (power generation or heavy manufacturing, for instance). Operating in other industries may require very few fixed assets (consulting or other professional services, for example). In still other industries, some companies choose to acquire operational assets such as buildings, computer systems, and vehicles, while other companies in the same industry utilize the same assets through operating lease or rental contracts which leaves asset ownership to another party. For these reasons, comparing total asset turnover ratios with "industry standards" or between companies should be done cautiously.
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Fixed Asset Turnover
The fixed asset turnover metric compares sales generated (net sales revenues from the income statement) to the value of the company's total fixed assets (also known as "Property, plant and equipment" or, sometimes, "operating assets"), from the balance sheet. It is a measure of how well the company generates revenue from assets that are not as liquid as current assets.
From the example financial statements below:
Net sales revenues = $32,983,000
Fixed Assets (Total Property, Plant & Equipment) = $9,716,000
Total Asset Turnover
= Net sales revenues / Total fixed assets
= $32,983,000 / $9,716,000
= 3.4 total fixed asset turns / year
For any company, fixed asset turnover will of course always be higher than total asset turnover.
Fixed Asset Turnover Rules of Thumb:
Fixed asset turnover rules of thumb are very similar to total asset turnover rules of thumb (previous section).
- The important information for any company in fixed asset turnover metrics has to do with year to year changes. Generally, fixed asset turnover rates should increase from year to year.
- Large investments in fixed assets are necessary in order to operate in some industries (power generation or heavy manufacturing, for instance). Operating in other industries may require very few fixed assets (consulting or other professional services, for example). In still other industries, some companies choose to acquire operational assets such as buildings, computer systems, and vehicles, while other companies in the same industry utilize the same assets through operating lease or rental contracts which leaves asset ownership to another party. For these reasons, comparing fixed asset turnover ratios with "industry standards" or between companies should be done cautiously.
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Sample Income Statement
Some of the data for activity and efficiency metrics were taken from this example income statement.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
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Sample Balance Sheet
Some of the data for activity and efficiency metrics were taken from this example balance sheet.
Grande Corporation Assets Liabilities Owners Equity |
For a complete introduction to financial metrics, including a working set of interrelated financial statements and over 100 financial metrics derived from them, see Financial Metrics Pro.
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