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An efficiency ratio, also known as a working ratio, shows a business how well it is doing by comparing the cost of running the business with the profit the business has made. A rough estimate of the efficiency ratio is determined by dividing the business's expenses by its revenue, or earnings. This number is then converted into a percentage and the lower the percentage, the better the business is doing. The efficiency ratio gives the business an idea of how much money it spends to earn one dollar of revenue. A ratio showing it spends more than a dollar for each dollar earned means the business is losing money and needs to change its methods to lower costs.
For example, a small business might make $10,000 US Dollars (USD) in one year and spend $5,000 USD that year to produce its products. To calculate its efficiency ratio, it would divide expenses by earnings, thus taking 5,000 and dividing it by 10,000 to get an answer of 0.5 or 50%. This tells the business it spent half of what it made on production and it must spend half of one dollar to earn one whole dollar. Thus the business has a 50% efficiency ratio. The business can then see if it can cut that number down any and find ways to ensure it does not increase. An efficiency ratio of 100% or higher indicates loss, not profit.
When calculating this ratio, a business looks to its overhead, a term that covers the business's annual operational expenses. Certain factors such as income taxes are not considered in overhead expenses. This allows the business to factor in solely the money it must actually spend on production and not money spent directly or indirectly for other purposes.
Various types of efficiency ratios exist. Each type targets a different aspect of the business to measure how well it is doing financially. The different efficiency ratios include inventory turnover, accounts receivable turnover, accounts payable turnover, and total asset turnover. Calculating the accounts receivable turnover ratio would show the business whether or not it is in good standing when comparing the amount of credit it issues compares to how much borrowers pay back. The other types of efficiency ratios perform similar tasks but focus on different areas, ranging from specific information about income to ratios that show how long it takes to earn money from a credit sale.
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