Efficiency, the ability to transform inputs into outputs, is a potential indicator of a company’s financial health. Companies with favorable efficiency levels are likely to be on investors’ radar irrespective of market conditions. 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 its price performance.

Ratios to Evaluate Efficiency Levels

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 patch 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. The 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 may indicate that the company efficiently collects its accounts receivables or has quality customers, a low ratio may signal 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 the 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 possibility that the company is utilizing its assets efficiently. On the contrary, a low value of the ratio may signal that it 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 ratios higher 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:  Higher value of these ratios than the industry averages may indicate that the efficiency level of the company is greater than its peers.    

The use of these criteria has narrowed down the universe of around 7,887 stocks to only 18. Here are the top five stocks:

Farmers & Merchants Bancorp Inc (FMAO - Free Report) operates as a bank holding company for The Farmers & Merchants State Bank that provides commercial banking, retail banking, and other financial services to individuals and small businesses in northwest Ohio and northeast Indiana. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 7.47%. 

Advanced Energy Industries, Inc. (AEIS - Free Report) is a provider of engineered, precision power conversion, measurement and control solutions. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 10.46%. 

NVR, Inc. (NVR - Free Report) is engaged in the construction and sale of single-family detached homes, townhomes and condominium buildings. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 14.19%. You can see the complete list of today’s Zacks #1 Rank stocks here.

Vertex Pharmaceuticals Incorporated (VRTX - Free Report) is engaged in discovering, developing, manufacturing and commercializing medicines for serious diseases. This Zacks Rank #1 company has an average four-quarter positive earnings surprise of 406.25%.

Sanderson Farms, Inc. (SAFM - Free Report) is a poultry processing company. The company 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. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 8.53%.