Efficiency as defined in investment terms is measured by the profitability or sustainability of a business. How well a company uses its assets and liabilities can be determined through ratio analysis and a comparison to its peers. Contrary to popular belief, efficiency does not have anything to do with management or customer service practices.
Common Efficiency Ratios
The most-often used efficiency calculation is a simple division of expenses by revenue. The resulting figure becomes relevant when compared with past performance to analyze a trend toward higher or lower profitability. Other ratios used in efficiency breakdowns include inventory turnover, sales to inventory and fixed asset turnover.
Measuring profitability is an essential part of due diligence and fundamental analysis when researching a stock. Understanding a company's balance sheet and how liabilities are matched up against assets reveals their effectiveness in generating a profit. The profit margin is a telling ratio that can be found by dividing net profit after costs by revenue. Like all efficiency ratios, the profit margin is most useful when compared with past data to determine positive or negative trending.
Ratio analysis doesn't exist in a vacuum. To understand what the ratios mean, a comparison must be made to peers to give the numbers meaning. If two similar businesses have varying profitability ratios, the resulting figures will reveal the differences in how each company manages its assets and liabilities.
Investment analysis is about assessing a company's ability to make a profit. While companies in the same industry may both generate profits, a closer look at how efficiently run the companies are can show which one stands to grow faster. Ratios aren't the only clear indicators of how efficiently profits are made by a business. A commonly quoted measure of efficiency is adaptation to a changing economic climate, something that may not be easily seen through ratio analysis.
- Modern Portfolio Theory and Investment Analysis: Edwin Elton et al.
- Getting Started in Fundamental Analysis: Michael Thomsett
- Creatas/Creatas/Getty Images