Activity and efficiency metrics
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt. Revised 12 January 2012.
The Meaning of Activity and Efficiency Metrics
Activity and efficiency metrics measure a company's ability to use its resources efficiently. They are sometimes viewed as measures 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
Eight of the most commonly used activity and efficiency metrics are defined, explained, and 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.
• Eight Activity and Efficiency Metrics Explained With Examples
– Sales Revenue per Employee
– Inventory Turns
– Days Sales in Inventory, Average Turnover Period, Days Inventory Outstanding (DIO)
– Days Payable Outstanding (DPO)
– Accounts Receivable Turnover
– Average Collection Period, Days Sales Outstanding (DSO)
– Total Asset Turnover
– Fixed Asset Turnover
• Sample Income Statement
• Sample Balance Sheet
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Eight Activity and Efficiency Metrics Explained With Examples
Sales Revenues per Employee
The Meaning of 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.
How is Sales Revenue per Employee Calculated?
This example uses the following data;
Net sales revenues for the year (from income statement): $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
The Meaning of 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. Inventories 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)
How is Inventory Turns Calculated?
The inventory turns example uses these data from the sample financial statements below:
Net sales revenues for the year (from income statement): $32,983,000
Cost of goods sold (CGS) for the year (from incomes statement): $22,043,000
Total inventories at period end (from balance sheet): $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 (Method 1 using Net Sales)
= Net sales revenues / Total inventories
= $32,983,000 / $5,986,000
= 5.5 turns / year
Note that the inventory Turns metric is sometimes computed using Cost of goods sold (CGS), or Cost of Sales in place of Net sales revenues. Whereas Net Sales Revenues represents the market value of goods, cost of sales for the period represents their actual cost to the company:
Inventory Turns (Method 2 using CGS)
= Cost of goods sold / Total inventories
= $22,043,000 / $5,986,000
= 3.7 turns / year
The second method using CGS will generally be lower or more conservative than Method 1 using Net Sales.
Note also, that "Average Inventory value" is sometimes used in place of "Total Inventories." The latter represents the end of period balance sheet figure. When there are substantial seasonal fluctuations in inventories, however, some analysts view the period average inventory value as the more appropriate representation.
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, or Days Inventory Outstanding, DIO)
The Meaning of Days Sales in Inventory (Average Turnover Period, or Days Inventory Outstanding, DIO)
The days sales in inventory (or average turnover period, or days inventory outstanding) 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.
How is Days Sales in Inventory (DSO, Average Turnover Period, DCays Inventory Outstanding, DIO) Calculated?
The days sales in inventory examples here use the following data:
Inventory turns per year (based on Net sales revenues): 5.5
Inventory turns per year (based on Cost of goods sold): 3.7
Days per year: 365 (some analysts prefer 360)
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, or average turnover period
(Method 1, using Inventory turns based on Net sales revenues)
= Days per year / Inventory turns per year
= 365 / 5.5
= 66.4 days
Note, however, that there are two commonly used approaches to calculating inventory turns per year (as shown in the section above). One inventory turn metric represents Net sales revenues divided by total inventories, but the other uses Cost of goods sold divided by total inventories (or average inventory). When the latter approach to inventory turns is used, the Days sales in inventory metric is more likely to be called Days inventory outstanding, or DIO).
Days inventory outstanding (DIO), or Days sales in inventory, Average turnover period
(Method 2, using Inventory turns based on Cost of goods sold)
= Days per year / Inventory turns per year
= 365 / 3.7
= 98.7 days
DIO, calculated this way is one of the three components of the liquidity metric, Cash conversion cycle (CCC), illustrated in the liquidity metrics pages. The two other CCC components are other efficiency metrics, Days sales outstanding (DSO) and Days payable outstanding (DPO).
Days Sales in Inventory Rules of Thumb
Since this metric carries the same information as the inventory turns metric (above), see the rules of thumb and guidelines 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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Days Payable Outstanding (DPO)
The Meaning of Days Payable Outstanding (DPO)
Days payable outstanding (DPO) is a measure of how long, on average, a company takes to pay its creditors.
How is Days Payable Outstanding (DPO) Calculated?
For this examples in this section, DPO uses the following income statement and balance sheet data (from the sample statements below):
Accounts payable (from balance sheet): $1,642,000
Cost of Goods sold (from income statement): $22,043,000
Number of days per year: 365 (some analysts prefer 360)
Days payable outstanding (DPO)
= (Accounts Payable / Cost of goods sold) * Days per year
= ($1,642,000 / $22,043,000) *365
= 27.2 days
DPO, calculated this way is one of the three components of the liquidity metric, Cash conversion cycle (CCC), illustrated in the liquidity metrics pages. The two other CCC components are other efficiency metrics, Days sales outstanding (DSO) and Days inventory outstanding (DIO).
Days Payable Outstanding Rules of Thumb
- The Days payable outstanding (DPO) metric does not measure how quickly a company can pay its bills (liquidity metrics, such as the quick ratio measure that). DPO measures how quickly the company does pay its bills. Good financial leadership will generally try to avoid paying as long as creditors allow, so as to use the funds for earning interest or otherwise working for company gain.
- Days payable outstanding should reflect the weighted average credit terms granted the company by its suppliers. The company in the example above, for instance, has a DPO of 27.2 days, suggesting that most of its creditors ask for "net 30 days" payment (a few may ask for "net 15" or immediate payment, bringing the average down a little below 30 days).
- A trend over time towards shorter DPS could indicate the company is getting increasingly poorer credit terms from its suppliers.
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Accounts Receivable Turnover
The Meaning of 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 considered less less productive than those that turn over quickly.
How is Accounts Receivable Turnover Calculated?
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 (from income statement): $32,983,000
Net accounts receivable (from balance sheet): $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 example 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 (DSO)
The Meaning of Average Collection Period (Days Sales Outstanding, DSO)
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.
How is Average Collection Period (Days Sales Outstanding, DSO) Calculated?
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 or Days sales outstanding (DSO) calculated this way is one of the three components of the liquidity metric, Cash conversion cycle (CCC), illustrated in the liquidity metrics pages. The two other CCC components are other efficiency metrics, Days inventories outstanding (DIO) and Days payable outstanding (DPO).
Average Collection Period (Days Sales Outstanding, DSO) 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
The Meaning of 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).
How is Total Asset Turnover Calculated?
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 (from income statement): $32,983,000
Total Assets (from balance sheet): $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 Meaning of 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.
How is Fixed Asset Turnover Calculated?
From the example financial statements below:
Net sales revenues (from income statement): $32,983,000
Fixed Assets (Total Property, Plant & Equipment, from balance sheet) = $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 150 financial metrics derived from them, see Financial Metrics Pro.
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