The efficiency ratio provides information on the credit union’s overhead costs. It compares expenses minus assessment expenses to operational income (interest income, fee income, and other operating income) minus interest expense plus provision for loan loss.
Put simply, it measures how much money it takes a credit union to earn $1 of revenue.
The formula looks like this:
Operating Expenses – Assessment Expenses
Operational Income – Interest Expense + Provision for Loan Loss
A high efficiency ratio means that a higher percentage of a credit union’s income is going to overhead expenses (i.e., the lower the efficiency ratio, the better).
One major factor that can change the efficiency ratio is the interest rate environment. Income is especially sensitive to interest rate changes, while expenses are not affected to the same degree. With a decline in operational income, the efficiency ratio can rise.
The efficiency ratio can be used to:
Observe long-term trends in expenses relative to income
Assess the need for greater expense control
Compare efficiency to that of peers