The ratios which are generally utilized to evaluate how well a business organization uses its liabilities and assets are known as efficiency ratio. The efficiency ratios are used to calculate the repayment of liabilities, turnover of receivables, usage of equity, quantity, general use of machinery and inventory.
Efficiency ratio is the ratio which is generally applied to banks, in simple terms it is described as expenses as a percent of revenue (revenue/ expenses) with slight differences. The lower percentage is better because expenses are low whereas the income or earnings are high. It is concerned with operating leverage that measures the ratio between the variable cost and fixed cost. Efficiency ratios evaluate the quality of the business’ receivables and how effectively it controls and uses its assets, how effectively the company is paying suppliers, and whether the company is undertrading or overtrading on its equity (utilizing borrowed funds).
Step to calculate efficiency ratio:
The easiest method to calculate or to find out the efficiency ratio is by taking the interest expensing that then dividing it by revenue. You could find this data in the financial information section of a business organization’s annual report or financial statement or 10-K.
Let us take an example of a bank annual report. The bank’s non-interest expenses are 3311million dollars and its total income 5500 million dollars. Then you will be getting 0.602 i.e. 3311 divided by 5500 and the answer you will get as 0.602 (3311/5500=0.602). Now you have to move the two decimal points to the right side and then you will get the efficiency ratio of 60.2 percent.
One you find the number, and then the next stage is to interpreting it. Generally the increasing efficiency ratio is not good; the reason is that the bank is spending a lot of cash on expenses. But the decreasing efficiency ratio is good, that means the bank is keeping the cost low or down.