A lot of young investors are taken in by the slew of IPOs in 2021 by brands that nearly all young people use on a regular basis.

We’re not taking any names here but what baffled a lot of experienced investors is the fact that some companies were knee-deep in losses. For one of them, in particular, the losses outshadowed their (admittedly high) income, the IPO proceeds would be used to clear up the company’s debt and by the company’s own admittance, the losses are expected to continue. Furthermore, a far larger fish has plans to enter the sector and could seriously disrupt things.

Why we need efficiency ratios

It would appear that the positive sentiment of investors keen on the company’s stock emerged solely from the company’s strong and highly visible brand presence. The positive sentiment appears to have been reinforced by investors focussing only on the company’s revenue/ turnover without focussing on its overall financial health.

You can’t say they were brainwashed because all the information is publicly available. And of course, for all we know, this was a strategic move to pocket listing gains for some or most or all of the investors. However, if you are looking for sustained capital growth in the long term, while minimising your risk by investing in financially strong companies, you might not have made the same choice.

Efficiency ratios can help you make the right choice in terms of companies that display strong financial health and potential for growth.

What are efficiency ratios

Efficiency ratios are a practice in fundamental analysis of companies. Fundamental analysis looks beyond the stock price and digs deep into the company’s financials to evaluate its ability to earn and therefore experience stock price increase, thereby delivering earnings to investors.

Efficiency ratios may be defined as a measure of a company’s capabilities with regards to using its resources to maximize its earnings.

How to use efficiency ratios to invest wisely

By using efficiency ratios investors can prevent themselves from getting distracted by big, shiny figures that present only a part of the pictures because they offset revenue with expenses and evaluate how much a company spends to run its business and bring back profits.

Since they are not absolute numbers, but ratios, they can also be used as a generic yardstick to compare different companies within the same sector.

Many investors have seen how companies with higher efficiency ratios, also display a higher propensity to deliver profits. You can even backtest this yourself once you wrap your head around them after reading this post.

Types of efficiency ratios

The following four ratios are most commonly used on fundamental analysis of stocks. Business accounting might also use a few additional ratios, but as far as fundamental analysis of companies for stock market investment goes, these four are the go-to:

– Inventory turnover ratio

– Asset turnover ratio

– Accounts receivable turnover ratio

– Accounts payable turnover ratio

Inventory turnover ratio

The formula for inventory turnover ratio is cost of goods sold ÷ average inventory

A higher inventory turnover bodes well for a company. It means that goods are being sold quickly and less stock is sitting idle. The cost of good sold is arrived at by adding up materials, labour, utilities etc. The average inventory is arrived at by taking an average of the cost of goods during two or more specified time periods. It usually includes at least beginning inventory balance and closing inventory balance of the same year.

So if the cost of goods sold by company A is Rs 12 lakh and the average inventory is 4 lakh whereas the cost of goods sold by company A is Rs 16 lakh and the average inventory is 8 lakh, we can easily figure out which one is a preferable investment by this yardstick.

Company A has an  inventory turnover efficiency ratio of 3, while company B has an inventory turnover ratio of 2. By this yardstick, company A comes across as potentially more likely to deliver profits.

Asset turnover ratio

The formula for asset turnover ratio is net sales ÷ average total assets

This ratio tells the investor how much it costs for the company to churn out it’s revenue.

You can find net sales on the company’s balance sheet but do remember to deduct returns and refunds from this amount. Average assets can be arrived at by adding assets at the start and end of the fiscal and dividing it by two.

Here too you are looking for a higher asset turnover ratio that tells you that a company is making good use of its assets to bring home profits.

Accounts receivable turnover ratio

The formula for accounts receivable turnover ratio is net credit purchases ÷ average accounts payable

When you use this ratio, you must also compare it from one year (or one quarter or one period) to the next. This ratio tells you how quickly a company is paying off suppliers. Early payment enrikes companies to discounts; late payment could attract penalties. Companies that are unable to pay on time could be headed for financial downfall. An inability to pay dues on time is a red flag overall (that’s also why banks consider your credit score – which is linked to whether you pay your credit card bills on time – before lending to you).

Accounts payable turnover ratio

The formula for accounts payable turnover ratio is net credit sales ÷ average accounts receivable

You’re looking for a higher ratio as is the case with any other efficiency measure and like it’s accounts receivable counterpart, here too it makes sense to compare the company’s current efficiency levels with historical levels.

A company must have systems and tools in place to get it’s payments on time. Why should working capital be sitting anywhere but in the company’s (or shareholder’) hands?

Conclusion

Use these ratios to determine a company’s financial health. Use them along with other ratios in fundamental analysis like P/E ratio and price to sales ratio to find out if now is a good time to invest in a company’s stock.

However, even once you have achieved all of that, do not lose sight of stock market risk. Always consider your risk appetite before investing and do your best to buy stocks with capital that you manage to put aside after your daily basic and lifestyle expenses.