4 efficiency ratios to consider before investing in a mutual fund

Mutual funds are pooled investment vehicles wherein asset management companies raise the capital from different investors. Such funds mitigate the risk of investing in the stock market by way of diversification. To thoroughly assess a mutual fund, you must identify its components or the top stocks that comprise most of the fund. One excellent tool you can do this with is an efficiency ratio. Efficiency ratios evaluate the robustness of a company’s operations

Efficiency ratios are a category of financial ratios that quantify and indicate how efficiently a business is managed. They are expressed as a number. A higher number indicates higher efficiency.

Types of efficiency ratios

There are four commonly used efficiency ratios.

1.     Inventory Turnover Ratio (ITR)

ITR = Cost of Goods Sold / Average Stock

Average Stock = (Opening Stock + Closing Stock) / 2

A higher ITR indicates that the inventory management system adopted by a company is working well. This is an essential differentiator while comparing various investment options in the stock market. It subtly indicates the managerial ability of a company and how it trickles down to shop floor operations.

  1. Asset Turnover Ratio (ATR)

ATR = Net Sales / Average Total Assets

Average Total Assets = (Opening Total Assets + Closing Total Assets) / 2

ATR indicates the revenue earned by a company for each rupee invested in an asset. So, an ATR of 2 means that for every rupee of asset, the company earns Rs. 2.

  1. Debtors or Receivables Turnover Ratio (DTR)

DTR = Net Credit Sales / Average Accounts Receivable

Average Accounts Receivable = (Opening Receivables + Closing Receivables) / 2

DTR captures the impact of the terms and conditions of repayment from customers. It reveals the efficiency of the collection and indirectly hints at a company’s reputation, which also influences its stock market movements.

  1. Creditors or Payables Turnover Ratio (CTR)

CTR = Net Credit Purchases / Average Accounts Payable

Average Accounts Payable = (Opening Payables + Closing Payables) / 2

This ratio indicates how efficiently the company is managing its payment cycles. A higher ratio is indicative of more cash available and is preferred.

Applying efficiency ratios to decide which stocks to buy

Before investing in a mutual fund, analyse it by following these steps:

  • List the top components of the mutual fund you are considering
  • For each component, obtain the complete financial statements
  • If the ratios discussed above are already available, calculate the ratio-wise average to get the corresponding ratio for the mutual fund
  • If the ratios are unavailable, use the formulae given above to get the ratio for each company and then calculate the average to arrive at the fund’s ratios
  • Repeat this exercise for various mutual funds
  • The fund with the highest efficiency ratios would be the most preferable option

Investment decisions based on such ratios

Efficiency ratios help distinguish between well-managed and poorly managed organisations. Simple and easy to calculate and interpret, they’ll help you to sift through the thousands of entities listed on the stock market.

For assistance with analysing stocks using ratios and making sound investment decisions to navigate today’s stock market wisely, it is prudent to reach out to a financial advisor.