What it means
Banks are a good place to start, because the efficiency ratio was designed for them. A bank earns money from the gap between the interest it charges on loans and the interest it pays on deposits, plus fees.
It then spends money on staff, branches, technology and marketing, and the ratio compares those running costs with the money coming in. A ratio of 60% means the bank spends 60 cents on operating costs for every dollar of revenue, leaving 40 cents before loan losses and tax.
Lower is better, because it means a larger share of each dollar flows through to profit. Many banks aim for a figure below 60%, and the best performers often manage far lower.
The ratio is useful because it can be tracked over time and compared with rivals. If it rises, costs are growing faster than revenue, which is a signal for management to investigate.
If it falls, the bank is either cutting costs or growing income without matching cost increases. Outside banking, the phrase efficiency ratio is used more loosely.
It can refer to a group of measures, such as asset turnover, inventory turnover or receivables turnover, that show how well a company uses its resources. When you meet the term, check which definition the speaker has in mind.
The ratio has limits. Cutting costs too sharply to improve the ratio can damage service, hold back investment in technology and weaken risk controls.
A bank with a very low ratio might simply be under-investing, so the figure should be read together with growth, customer satisfaction and loan quality. Boards and investors typically set targets for the ratio and track it quarterly.
A common approach is to compare it with the average of five or six similar banks, so that differences in size and customer base are taken into account. Management bonuses are sometimes linked to the ratio, which makes it important to define the numerator and denominator precisely.
In practice
Real-world examples
Example 1
A regional bank reports an efficiency ratio of 68% against a peer average of 58%. The chief executive asks the finance team to look at branch costs, since the bank has more branches than customer numbers justify. Over two years, closing overlapping branches brings the ratio down to 61%.
Example 2
An investor compares two banks with similar profits. One has an efficiency ratio of 52% and the other has 75%. She concludes that the first bank has stronger cost control, and she asks whether the second bank's higher costs reflect investment that will pay off later.
Example 3
A manufacturing company uses the term loosely and reports an efficiency ratio of inventory turnover and receivables turnover. The new finance director asks the team to state exactly how each measure is calculated, so that board members are not comparing different definitions.
Think of it
Efficiency ratio shows what percentage of revenue goes to operating the business versus flowing to profit.
Formula
Calculation
Efficiency ratio (banking) = Non-interest expense / Total revenue x 100
Total revenue = Net interest income + Non-interest income
Suppose a bank has net interest income of $75,000,000 and non-interest income (such as fees) of $25,000,000.
Total revenue = 75,000,000 + 25,000,000 = $100,000,000.
Non-interest expense, covering salaries, premises and technology, is $60,000,000.
Efficiency ratio = 60,000,000 / 100,000,000 = 0.60, or 60%.
If the bank cut costs by $5,000,000 with revenue unchanged, the ratio would fall to 55,000,000 / 100,000,000 = 55%.Case study
Seen in the real world
Meridian Community Bank is an illustrative, fictional lender whose efficiency ratio had risen from 58% to 66% in three years. Revenue was growing, but costs were growing faster.
The finance team traced the rise to a costly core banking system upgrade and to staffing in branches that handled fewer and fewer transactions. They launched a plan to automate back-office tasks and to shift routine services to the mobile app.
Within two years the ratio fell back to 60%, and the illustrative lesson is that the ratio is a prompt to ask why costs are moving, rather than a target to hit by cutting indiscriminately.
Watch out
Common mistakes
- Assuming a lower ratio is always better, when extreme cost-cutting may harm service or growth.
- Including interest expense in the numerator for a bank, when the standard measure uses non-interest expense.
- Comparing a bank's efficiency ratio with that of a non-bank company, as the definitions differ.
Questions
People also ask
What is a good efficiency ratio for a bank?
Lower is better, and many banks aim for something below 60%, but the right level depends on the business model and the cost of the markets served.
Is the efficiency ratio the same as operating margin?
No, it is a related idea, but the efficiency ratio shows costs as a share of revenue, while operating margin shows profit as a share of revenue.
Why do analysts look at the trend as well as the level?
A rising ratio signals that costs are growing faster than income, which can be an early warning of weaker profitability.