Efficiency, a company’s ability to transform its inputs into outputs, is a potential indicator of a company’s financial health. This is because a company with a favorable efficiency level is expected to provide impressive returns as it is believed to be positively correlated with the company’s price performance. But, it is difficult to measure the efficiency level of a company. This is the reason why one must consider popular efficiency ratios while selecting stocks to build a profitable portfolio.

How to Measure Efficiency?

We have considered four popular ratios in order to find efficient companies that have the potential to provide impressive returns.

Inventory Turnover

Inventory level is one of the key indicators of a company’s business health. While a high inventory level may indicate that the company is going through a rough phase in terms of sales, a dwindling level may indicate that the company will run out of stock in a favorable sales condition. This is where inventory turnover comes into play. It is the ratio of 12-month cost of goods sold (COGS) to a 4-quarter average inventory. Thus, a high value of the ratio indicates a low level of inventory relative to COGS, while a low ratio signals that the company has excess inventory.

Receivables Turnover

This ratio is used to measure a company’s capability to extend its credit and collect debts on the basis of that credit. Receivables turnover ratio or the “accounts receivable turnover ratio” or the “debtor’s turnover ratio” is calculated by dividing 12-month sales by four-quarter average receivables. While a high ratio indicates that the company efficiently collects its accounts receivables or has quality customers, a low ratio signals that the company has an inefficient collection procedure or has low-quality customers or an inefficient credit policy.

Asset Utilization

This is a widely used measure of a company’s efficiency. Asset utilization indicates a company’s potential to utilize its assets. It is a ratio of total sales over the past 12 months to the last 4-quarter average of total assets. So, the higher the ratio, the greater is the chance that the company is utilizing its assets efficiently. On the contrary, a low value of the ratio implies that the company is failing to use its assets effectively.

Operating Margin

Another popular efficiency ratio is operating margin. Operating profit margin, which is simply operating income over the past 12 months divided by sales over the same period, indicates how well a company is controlling its operating expenses. If a company has a high operating profit margin in relation to its competitors, it is doing a better job at controlling operating expenses.

All these ratios can be considered as effective measures if one compares different companies within a particular sector or industry. This is the reason why we have considered only those companies that have higher ratios than their respective industry averages.

Screening Parameters

In addition to the above-mentioned ratios, we have added a favorable Zacks Rank – Zacks Rank #1 (Strong Buy) or 2 (Buy) – to the screen with an objective to make this strategy more profitable.

Inventory Turnover, Receivables Turnover, Asset Utilization and Operating Margin greater than industry average

(Values of these ratios higher than industry averages may indicate that the efficiency level of the company is higher than its peers.)    

The use of these few criteria narrowed down the universe of over 7,906 stocks to only 18.

Here are five stocks from the 18 that made it through the screen:

Sanderson Farms, Inc. (SAFM - Free Report) is engaged in the production, processing, marketing and distribution of fresh and frozen chicken, and also preparation, processing, marketing and distribution of processed and minimally prepared chicken. The company has a Zacks Rank #1. The company has an average four-quarter positive earnings surprise of 8.53%.

American Woodmark Corporation (AMWD - Free Report) manufactures and distributes kitchen cabinets and vanities for the remodeling and new home construction markets. The company, with a Zacks Rank #2, has an average four-quarter positive earnings surprise of 12.94%.

Vertex Pharmaceuticals Incorporated (VRTX - Free Report) is engaged in discovering, developing, manufacturing and commercializing medicines for serious diseases. The company has a Zacks Rank #2. It has an average four-quarter positive earnings surprise of 406.25%. You can see the complete list of today’s Zacks #1 Rank stocks here.

Baxter International Inc (BAX - Free Report), through its subsidiaries, provides renal and hospital products. The company has a Zacks Rank #2. The company has an average four-quarter positive earnings surprise of 17.14%.

A. O. Smith Corp (AOS - Free Report) manufactures and markets residential and commercial gas, gas tankless, electric water heaters, and water treatment products in North America, China, Europe, and India. The company has a Zacks Rank #2. The company has an average four-quarter positive earnings surprise of 4.88%.