What is an Efficiency Ratio?
By Nichole Karas
, last updated January 24, 2012
An efficiency ratio is a measure of how effective a company manages its production and resources. There are many ratios that can be calculated to measure efficiency within specific areas of a business, including stock turnover ratios and sales to inventory ratios, but the most basic and broadly informative efficiency ratio is an expenses to revenue ratio. The expenses to revenue efficiency ratio, calculated by (expenses/revenue), measures how many dollars a company needs to spend in order to earn one dollar of revenue. The expenses to revenue efficiency ratio for a company that is not losing money is between 0 and 1, and the lower the ratio is the more efficient a company is in creating revenue.
It is important to recognize that when using an efficiency ratio as an evaluation tool, whether it be for a potential investment in a company or a self-evaluation of your own company that these ratios are only useful as comparable tools within industries. Because the efficiency ratio essentially shows how profitable a company is regardless of size, it does not make sense to use it to compare companies in industries that may have very different levels of profitability.
For example, because the technology sector often has significantly wider profit margins than the energy industry, an expenses to revenue efficiency ratio would not be useful in a comparative evaluation between Exxon Mobil and Apple Computers. The efficiency ratio can however be very useful in comparing how well industry competitors manage their resources, and potentially show that a company is not managed as efficiently as other firms in the industry. Significant further research would be necessary to make any specific determinations, but using this efficiency ratio as a tool for comparison could indicate that the current structure of the company is limiting productivity, but also that there are efficiency improvements that may be able to be made to increase future profitability.
Here is a real life example based on figures reported to the Securities and Exchange Commission for 2010, in millions of dollars. AT&T had $124,280 in revenue and $104,707 in expenses, Verizon had $106,565 in revenue and $91,920 in expenses. Google had $29,321 in revenue and $18,940 in expenses. Using the (expenses/revenue) formula, in 2010 AT&T had an efficiency ratio of .84, Verizon had an efficiency ratio of .86 and Google had an efficiency ratio of .64. It would appear that Verizon was slightly more efficient than AT&T in 2010, but this may not necessarily be true.
It could be that AT&T had higher expenses than normal because of investment in infrastructure that will increase revenues in future years, and is actually a more efficiently run company. Google with an efficiency ratio of .64 appears to be significantly more efficient than the two telecommunications companies, but that is likely in part because of higher profitability and lower infrastructure costs for the technology sector. These reasons are why efficiency ratios may be misleading and do not always tell the full story of a company.