Operating Performance Ratios

Operating performance ratios are tools which measure the function of certain core operations for an organization or business. Particularly, these ratios reveal information about how efficiently that organization is using resources to generate sales and cash. A company with strong performance ratios is able to utilize a minimum resource pool to generate high levels of sales, as well as a significant cash inflow. In this tutorial, we’ll examine some of the most commonly used operating performance ratios. By reading this blog, you should come away with a general sense of what these measures are, how they are determined, and what information or insight they can provide to those within a company or interested in investing.

3 Main Operating Performance Ratios

There are three primary operating performance ratios we will consider. They include the following:

1. Fixed-asset turnover

2. Sales/revenue per employee

3. Operating cycle

Each of these ratios utilizes different inputs to measure varied portions or segments of a business’ overall performance.

(1) Fixed Asset Turn Over Ratio:

Before we can begin to consider what fixed-asset turnover is, it’s helpful to review what fixed assets are in the first place. A fixed asset is any tangible piece of property, used over the long term, which a company owns and uses in its general operations. They are also known as capital assets like Property, Plant, and Equipment (PP&E).

Although fixed assets represent only one type of assets a company owns, in many cases they are the largest share of the total asset pool. Fixed-asset turnover, then, is a ratio which aims to measure how productive a company’s fixed assets are when it comes to generating sales. The higher that the yearly turnover rate on these assets is, the better the company is at managing them and using them to generate sales.

The formula for fixed-asset turnover is as follows:

Fixed-asset turnover ratio = Revenue/PP&E

For a hypothetical company with annual revenue of $1 million and average fixed assets, or PP&E, of $200,000, the fixed-asset turnover ratio would be as follows:
$1,000,000/$200,000 = 5

To calculate a company’s fixed-asset turnover ratio, it’s useful to look to a company’s income statement for revenue figures and to a balance sheet for PP&E details.

Variations

There are ways to vary the fixed-asset turnover ratio to reflect other types of efficiency. For instance, some asset-turnover ratios make their calculations based on total assets. While it could be argued that this provides a fuller picture of a company’s activity, some analysts prefer fixed-asset turnover ratios because they represent a sizable component of the  balance sheet and management decisions over different capital expenditures. The idea, then, is that capital investment and its results is, in fact, a better indicator of performance than what is evidenced in overall asset turnover.

It’s important to keep in mind that fixed-asset turnover ratios are relative. There is no specific number or threshold above which a company is doing a successful job at generating revenue from its fixed asset investments. Thus, a single calculation of fixed-asset turnover ratio is not particularly useful; rather, comparing this ratio for a single company over time or between similar companies is far more helpful.

Before placing too much trust in this particular ratio, it’s also important to keep in mind that different companies in varying industries have vastly disparate investments in fixed assets. For example, tech companies often have low fixed-asset bases relative to heavy manufacturing companies. Thus, a fixed-asset turnover ratio for a leading tech company is a less useful means of gauging performance than a similar ratio would be for a heavy manufacturing company.

Higher fixed-asset turnover ratios are often the result of comparably low investments in PP&E, rather than an indication of high sales. Companies which are not capital intensive, they are better able to generate high levels of sales on relatively low capital investment. However, some industries, such as natural resource companies, tend not to experience this.

(2) Sales/ Revenue per Employee:

While fixed-asset turnover ratio is a measure of a company’s use of its fixed assets as a means of generating sales, sales/revenue per employee examines the business benefit on the level of individual personnel. This is not to say that this ratio should be (or is) used as a way of determining the performance of individual employees. Rather, it still reflects the larger decisions of a company’s management. However, it is calculated by breaking down sales or revenue that the company earns as compared with the number of employees working for at company.

As in fixed-asset turnover, certain types of companies are naturally inclined to enjoy higher or lower ratios. The higher the ratio is, the better the company in question is at generating revenue given the number of employees that it maintains. Labor-intensive businesses like mass market retailers tend to be less productive according to this metric as compared with high-tech, high-product-value manufacturers.

Here is the formula for calculating sales/revenue per employee:

Sales/Revenue Per Employee = Revenue/Number of Employees (Average)

For a hypothetical company generating $2 billion in sales and employing an average of 5,000 employees for the same period, the sales/revenue per employee calculation would thus be as follows:

$2,000,000,000/5,000 = $400,000

To determine the figures to input for any given company, once again it is helpful to look to the company’s financials. The sales or revenue figure can be surmised from the income statement, while the average number of employees for that period is available in the annual report or Form 10-K.

Variations

It is also possible to determine an earnings per employee ratio by using net income instead of net sales or revenue.

Like the other operating performance ratios a single calculation of sales/revenue per employee is far less useful than several ratios which can be compared against one another. Look to how a company’s sales/revenue per employee changes from year to year, for example, or how it stacks up against ratios for similar companies or competitors.

It is less useful to compare companies in very different sectors or industries using this performance metric. Take, for example, a comparison of Microsoft and Wal-Mart, two major companies in different industries. Microsoft relies on technology and innovation to drive revenues, requiring a relatively small personnel complement in order to accomplish these goals. A massive retail store like Wal-Mart, on the other hand, is quite labor-intensive and employees many more workers. Thus, Microsoft may be likely to have a sales per employee ratio that is significantly higher than that of Wal-Mart. This is largely a reflection of the fundamental differences in how these companies operate.

Used appropriately, sales or revenue per employee can be a useful metric to assess personnel productivity for a company. It is best used as a tool for comparing industry competitors or a company’s performance across many years.

(3) Operating Cycle:

Operating cycle is the third type of operating performance ratio we’ll examine in this tutorial. It makes use of receivables, inventory, and payables and aims to represent management performance efficiency. It is often compared with the cash conversion cycle because it makes use of the same component parts. What is different, though, is that an operating cycle analyzes these components from the perspective of how well the company is managing operational capital assets, rather than from the impact those components have on cash.

The formula for an operating cycle calculation is as follows:

Operating Cycle (Days) = DIO + DSO – DPO

DIO = Days Inventory Outstanding

DSO = Days Sales Outstanding

DPO = Days Payable Outstanding

Components

DIO

To determine a company’s operating cycle, analysts must first calculate the various components used in the formula above. To compute DIO, follow these steps:

1) Divide the cost of sales (available on a business’s income statement) by 365 in order to find a cost of sales per day figure.

2) Calculate the average inventory figure by adding the year’s beginning (or previous year’s ending) amount and the ending inventory figure (both of these are available in the balance sheet); then, divide by 2 to obtain the average amount of inventory for the time period in question.

3) Divide the average inventory figure from step 2 by the cost of sales per day figure from step 1.

A company with cost of sales of $760 million and average inventory of $560 million, say, would have a DIO as follows:

$730 million/365 = $2 million (cost of sales per day)

DIO = $560 million/$2 million = 280 (days inventory outstanding)

DSO

DSO can be computed using net sales and accounts receiable figures and with the following sequence of steps:

1) Divide net sales (available on a company’s income statement) by 365 to determine a net sales per day figure.

2) Calculate the average accounts receivable figure by adding the year’s beginning (or previous year-end) amount and the ending accounts receivable amount, then divide by 2 to obtain the average over the time period in question.

3) Divide the average accounts receivable figure by the net sales per day figure.

The process of determining DSO is very similar to that for calculating DIO, although it uses different figures.

DPO

Like DIO and DSO, the process for determining DPO is straightforward. In this case, though, you’ll need the cost of sales and accounts payable figures for the company and time period in question. Use the following steps to calculate DPO:

1) Divide the cost of sales (available on the income statement) by 365 to determine a cost of sales per day figure.

2) Calculate the average accounts payable figure by adding the year’s beginning (or previous year-end) amount and the ending accounts payable amount, then divide by 2 to determine the average.

3) Divide the average accounts payable figure by the cost of sales per day figure.

Once you have DIO, DSO, and DPO figures, you can then plug them into the formula at the top of the chapter to determine a company’s operating cycle.

Variations

It’s common to express the three primary components of the operating cycle (DIO, DSO, and DPO) in terms of turnover as a times (x) factor. A days inventory outstanding of 280 days would therefore be expressed as turning over 1.3x annually (because 365 days/280 days = 1.3 times). Some analysts prefer the use of actual days as it is more literal and easier to understand from a conceptual standpoint.

Let’s compare two hypothetical companies with figures as follows:

	Company A	Company B
DSO	58 days	105 days
DIO	280 days	294 days
DPO	63 days	145 days
Operating Cycle	275 days	254 days

In terms of collecting on receivables, it appears from the DSO figures that company A is significantly more operationally efficient than company B. Common sense would dictate that the longer a company has money which remains uncollected, the greater the level of risk that it is taking. Is company B remiss in not collecting its receivables more efficiently? Or perhaps is it trying to add market share by allowing its customers easier payment terms?

These two companies have almost identical days inventory outstanding. In this case, both companies have DIO figures which are higher than the average company across industries. This, then, is likely a reflection of the industry in question, rather than poor efficiency. However, in order to get the fullest picture, it would be helpful to compare these two DIO figures against those of other companies in the same industry.

When it comes to DPO, company B has a major advantage. It is stretching out its payments to suppliers far beyond what company A is able to do. In a sense, it is more efficient at using other people’s money, but the reason for this is not immediately clear from these figures alone. An analyst would likely want to know what that means for the credit reputation of each of these companies, and why they are different.

Shorter Is Better?

It’s easy to assume that shorter is better when it comes to a company’s cash conversion cycle or its operating cycle. This is true in the case of the former, but not necessarily the case in the latter. Of course, there are many variables attached to the management of receivables, inventory, and payables, and these require many decisions on the part of managers.

For example, short payment terms may restrict sales. Minimal inventory levels may mean that a company is unable to fulfill orders on a timely basis, which likely means that some sales are lost. Therefore, it would appear that if a company is experiencing solid sales growth and reasonable profits, its operating cycle components should reflect a high degree of historical consistency. With that, we reach the end of our tutorial on operating performance ratios with a reminder: consistency of these ratios across a company’s history is one of the most important measures of success.