Efficiency Ratio Explained: Definition, Formula, and Banking Example

What is an efficiency ratio?

An efficiency ratio measures how effectively a company uses its assets and liabilities to generate income. It’s part of a family of activity ratios that quantify short-term operational performance—how quickly a business converts resources (receivables, inventory, fixed assets) into sales or cash.

Key takeaways

• Efficiency ratios assess operational effectiveness and short-term performance.
• Lower values typically indicate better performance; for banks, a ratio under 50% is often regarded as strong.
• Ratios are most meaningful when compared with industry peers or tracked over time.
• Common efficiency metrics include accounts receivable turnover, inventory turnover, and fixed-asset turnover.

Efficiency ratios commonly used

• Accounts receivable turnover = Net credit sales / Average accounts receivable — measures how quickly customers pay.
• Inventory turnover = Cost of goods sold / Average inventory — shows how rapidly inventory is sold and replaced.
• Fixed-asset turnover = Net sales / Average fixed assets — indicates how productively a company uses its property, plant, and equipment.

Efficiency ratio in banking

In banking, the efficiency ratio has a specific and widely used meaning: it shows how well a bank controls overhead costs relative to its revenue. A lower ratio means the bank spends less to generate each dollar of revenue.

Standard banking formula:
Efficiency ratio = Non‑interest expenses / (Net interest income + Non‑interest income)

Notes:
* Non‑interest expenses are operating costs (salaries, occupancy, technology, etc.).
* Revenue generally includes net interest income plus non‑interest income (fees, trading revenue, service charges).

A declining efficiency ratio indicates improving cost control or rising revenue; a rising ratio signals higher expenses or falling revenue. Many analysts consider an efficiency ratio at or below 50% to be strong for a bank, though acceptable levels vary by institution and business model.

Banking example

Example: A bank reports an efficiency ratio of 57.1% this quarter versus 63.2% in the same quarter last year. The decrease means the bank became more operationally efficient, contributing to an $80 million increase in assets for the quarter. In practical terms, the bank spent less (or generated more revenue) per dollar earned, improving profitability.

How analysts use efficiency ratios

• Trend analysis: track improvements or deteriorations in operational performance over time.
• Peer comparison: benchmark a company against industry rivals to identify relative strengths or weaknesses.
• Diagnostic tool: isolate areas for improvement (e.g., slow collections, excess inventory, high back‑office costs).

Limitations and cautions

• Ratios vary by industry—what’s good for one sector may be poor for another.
• One ratio alone doesn’t tell the whole story; combine with profitability, liquidity, and leverage metrics.
• Accounting differences and one‑time items can distort short‑term ratios.

Bottom line

Efficiency ratios provide a concise view of how well a company converts resources into revenue and manages operating costs. They are most useful when compared with peers and tracked over time. For banks, the non‑interest expense divided by total revenue metric is a key indicator of overhead control: lower is better, and sustained improvements typically support stronger profitability.