Efficiency level, which measures a company’s capability to transform its available input into output, is often considered to be an important parameter to find out whether a company has the potential to yield higher returns or not. Companies with favorable efficiency levels are poised to be on investors’ radar irrespective of market conditions as price performance is believed to be positively correlated with the efficiency level.  

Key Ratios to Identify Efficiency

Sometimes it becomes 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. These efficiency ratios are:

Inventory Turnover:The ratio of 12-month cost of goods sold (COGS) to a 4-quarter average inventory is considered to be one of the most popular efficiency ratios. It indicates a company’s ability to maintain a suitable inventory position. While a high value indicates that the company has a relatively low level of inventory compared to COGS, a low value indicates that the company is suffering from weak sales, which resulted in excess inventory. 

Receivables Turnover:  This is the ratio of 12-month sales to four-quarter average receivables. It shows a company’s potential to extend its credit and collect debt in terms of that credit. A high receivables turnover ratio or the “accounts receivable turnover ratio” or the “debtor’s turnover ratio” is desirable as it signals that the company is capable of collecting its accounts receivables or that it has quality customers.

Asset Utilization:This ratio indicates a company’s capability to convert its assets into output and is thus a widely known measure of efficiency level. It is calculated by dividing total sales over the past 12 months by the last 4-quarter average of total assets. Like the above two ratios, high asset utilization may also indicate that a company is efficient.

Operating Margin:This efficiency measure is the ratio of operating income over the past 12 months to sales over the same period. It measures a company’s ability to control its operating expenses. Hence, a high value of the ratio may indicate that the company manages its operating expenses more efficiently than its peers.

As efficiency level varies across different industries, it is best to select those stocks that have higher ratios compared to their industries. Along with higher ratios, we have considered only those stocks that have either a Zacks Rank #1 (Strong Buy) or a Zacks Rank #2 (Buy) in order to make the strategy more profitable.

Screening Parameters

Inventory Turnover, Receivables Turnover, Asset Utilization and Operating Margin greater than industry average:  The values of these ratios higher than the industry averages may indicate that the efficiency level of the company is higher than its peers.    

Zacks Rankless than or equal to #2: Only Strong Buy and Buy rated stocks can get through.

The use of these very few criteria has narrowed down the universe of over 7,700stocks to only 9.

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

Imperial Oil Limited (IMO Quick QuoteIMO - Free Report) is Canada's largest integrated petroleum company. It has a projected EPS growth rate of more than 100% for the current year. The stock sports a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Reliance Steel & Aluminum Co. (RS Quick QuoteRS - Free Report) is one of the largest metals service center companies in the U.S. This Zacks Rank #2 (Buy) company has a projected EPS growth rate of 23.7% for the current year.

Pacific Ethanol, Inc. is currently in the business of marketing ethanol. This Zacks Rank #2 company has a projected EPS growth rate of greater than 100% for the current year.

Electronic Arts Inc. (EA Quick QuoteEA - Free Report) develops, markets, publishes, and distributes games, content, and services for consoles, personal computers, mobile phones, and tablets worldwide. This Zacks Rank #2 company has a projected EPS growth rate of 18.2% for this year.

Commerce Bancshares, Inc. (CBSH Quick QuoteCBSH - Free Report) operates as the bank holding company for Commerce Bank. This Zacks Rank #2 company has a projected EPS growth rate of 5.4% for the year.  

While backtesting over a two-year timeframe (Dec 26, 2014 to Dec 30, 2016), considering a four-week holding period, a portfolio following this strategy provided a total return of 20.6% compared with the S&P 500’s return of 7%. Thus, this strategy may prove to be profitable for investors seeking healthy returns.

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.

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