Efficiency Ratio

When it comes to the performance of banks, the efficiency ratio is defined as the ratio of non-interest expenses to total revenue.

Efficiency Ratio Formula:

Where Total Revenue is the sum of net interest income and non-interest income.

Efficiency Ratio Example: If a bank has an operating expense of $50B in a quarter and earns a revenue of $100B in the same quarter, then the Efficiency would be:

($50B / $100B) × 100 = 50%

For banks, managing costs is equally important as growing revenue. That’s where the efficiency ratio comes in. Non-interest expenses are often referred to as operating expenses, and the efficiency ratio is also called the operating expense ratio. Efficiency ratio is an indicator of how well a bank is controlling its day-to-day expenses compared to how much money it’s making.

In simple terms, a lower efficiency ratio is better. It means the bank is spending less to earn each dollar of revenue—an important sign of strong financial management. Over time, banks with lower efficiency ratios tend to be more profitable because they keep more of what they earn, which means that the bank generates higher profits for its shareholders.

The efficiency ratio is a key metric to watch for anyone looking to understand how financially healthy a bank is, especially investors and analysts.

Key Components used for efficiency ratio calculation are as follows -

1. Non-Interest Expenses or Operating Expenses

Operating expenses include the basic costs of day-to-day operations, which typically include:

• Employee salary and wages
• Rent and utility bills
• Tech costs such as software, hardware, subscriptions, licenses, etc.
• Insurance costs
• Office supplies
• Advertising and marketing costs
• Outsourced professional services such as legal, audit, consulting

Any other miscellaneous costs of running a business that are not related to paying interest on debt fall under this category.

2. Revenue

Revenue is the sum of Net Interest Income (NII) and Non-Interest Income. These are defined as -

• Net Interest Income (NII): This is the difference between the interest income a bank earns on assets such as mortgages, loans and securities and the interest it pays on liabilities such as deposits and borrowed debt.

  Net Interest Income (NII) = Interest Income - Interest Expenses

• Non-Interest Income: This income refers to the income earned by the bank from all sources other than interest. A significant portion of this income comes from fees, such as

  • Account fees
  • Transaction fees
  • ATM withdrawal fees
  • Mortgage origination fees
  • Wealth management fees
  • Asset management fees

  Some other common income sources included in this category include investment income, trading income, foreign exchange income, and safety deposit box rentals.

Like the banking efficiency ratio, which assesses banks' cost efficiency, other types of efficiency ratios measure companies' operational cost control or resource turnover in different industries based on various parameters. The commonly used ratios are listed below:

Operational Efficiency Ratios

1. Operating Ratio: Operating Expenses ÷ Net Sales
2. Cost-to-Income Ratio: Operating Costs ÷ Operating Income
3. Administrative Expense Ratio: Admin Expenses ÷ Net Sales

Asset and Turnover Efficiency Ratios

1. Inventory Turnover Ratio: Cost of Goods Sold ÷ Average Inventory
2. Asset Turnover Ratio: Net Sales ÷ Average Total Assets
3. Accounts Receivables Turnover Ratio: Net Credit Sales ÷ Average Accounts Receivable
4. Accounts Payables Turnover Ratio: Purchases ÷ Average Accounts Payable
5. Fixed Asset Turnover Ratio: Net Sales ÷ Average Net Fixed Assets

Cash Flow Efficiency Ratios

1. Operating Cash Flow Ratio: Operating Cash Flow ÷ Current Liabilities
2. Cash Conversion Cycle: Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) - Days Payables Outstanding (DPO)

Other

Several industries have industry-specific efficiency ratios, such as

• Cost per available seat mile in the airline industry
• Sales per square foot in the retail industry

The efficiency ratio is a metric of a company’s operational health. It tells us how effectively the company uses its resources to turn revenue. It is useful for the following reasons:

1. Analyze Performance: First and foremost, it measures how much revenue is spent on operational costs. A lower efficiency ratio means the company spends less to generate each revenue dollar, often indicating higher profitability.

2. Compare with Competitors: It helps compare a company’s efficiency with its industry peers and benchmark against them.

3. Analyze Trends: Tracking efficiency over time can help establish trends, such as whether operational efficiency is improving or deteriorating. Sudden spikes or drops can indicate key events, such as a one-time investment or the sale of an asset. Analyzing a trend can be helpful for both investors and management. A low and steady efficiency ratio can boost investor confidence, while an increasing efficiency ratio can prompt the management to make operational decisions.

4. Cost Control: If the efficiency ratio is too high, it indicates high operational costs relative to revenue. This encourages management to control their expenses to streamline operations and reduce operational expenses.

Factors that affect efficiency ratios can be broadly divided into two categories: Operational factors, which are within the company’s control, and market factors, which are beyond the company’s control.

Operational Factors

These factors are based on internal decision-making and are in the company’s control. Some of them are:

1. Staff: Salaries, wages, bonuses and benefits of the employed staff.
2. Offices and branches: Rent, lease or other expenses related to maintaining offices and branches. This expenditure can be controlled by shutting down branches or downsizing.
3. Technology investments: Investment in software, hardware, analytics tools, maintaining digital platform, etc.
4. Marketing costs: Expenditure on marketing campaigns and customer acquisition.
5. Mergers and acquisitions: Merging with or acquiring another company to expand the customer base and achieve better economies of scale.
6. Outsourced services: Outsourcing services to vendors at negotiated costs.

Apart from the above, decision-makers at the company level can control innumerable other factors.

Market Factors

These are factors that are beyond the company’s control yet can significantly impact the efficiency ratio.

1. Broader economic conditions: The economic environment, such as a boom or a recession, can impact revenue.
2. Interest Rate Environment: Higher interest rates can boost interest income, adding to revenue, while lower interest rates can shrink the revenue.
3. Inflation: Inflation can either drive costs higher, increasing the efficiency ratio, or, in some cases, demand-driven inflation can boost income, causing the efficiency ratio to drop.
4. Regulatory Effects: Regulatory changes can affect income or expenses. For example, fee caps can affect non-interest income, while new compliance requirements can impact operational expenses.
5. Customer Demand: Demand from customers related to loans, deposits, wealth management, trading, FX, etc, can have an influence on the revenue. A higher demand can drive higher revenues while a drop in demand can lower revenues.