Efficiency Ratios: Measuring Business Performance
- While profitability ratios assess how much money your business makes, efficiency ratios evaluate how well your company controls its operations.
- These ratios focus on:
- Stock management: ensuring optimal inventory levels
- Debt settlement speed: how quickly the business repays its obligations
- Credit control efficiency: how long customers take to settle accounts
- Capital financing structure: the reliance on loan capital versus shareholder funds
- Efficiency ratios often appear in case studies.
- Keep in your back pocket the common ways of interpreting them and recommend improvements.
Stock Turnover: How Quickly Inventory is Sold
Stock Turnover Ratio
The Stock Turnover Ratio measures how often a company sells and replaces its inventory within a given period.
- It reflects the efficiency of inventory management and indicates how well the company is converting its stock into sales.
Stock Turnover Formula
$$\text{Stock Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Stock}}$$
- Two key considerations:
- Cost of sales is used instead of revenue, as it reflects the actual cost of goods sold.
- Average stock is calculated as:
$$\text{Average Stock} = \frac{\text{Opening Stock} + \text{Closing Stock}}{2}$$
OR
Stock turnover ratio in days:
$$\text{Stock Turnover Ratio in Days} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} \times 365 \text{ days}$$
This ratio is expressed as the number of times inventory is sold and replaced in a given period.
- Many students confuse stock turnover with revenue.
- Remember, it focuses on inventory movement, not sales.
Interpreting Stock Turnover
- High turnover (e.g., fresh food retailers) suggests efficient stock movement but may lead to stock shortages.
- Low turnover (e.g., antique shops) may indicate obsolete stock or slow sales.
Debtor Days: How Long Customers Take to Pay
Debtor Days
Debtor Days (also known as Receivables Days) measures the average number of days it takes for a company to collect payments from its customers after a sale.
- It reflects the efficiency of the company’s credit control and collection practices.
Debtor Days Formula
$$\text{Debtor Days} = \frac{\text{Debtors} \times 365}{\text{Total Sales Revenue}}$$
Using the Debtor Days Ratio
- Lower debtor days = Faster cash collection, better liquidity.
- Higher debtor days = Potential cash flow problems but may attract more customers by offering longer credit terms.
- Businesses may reduce debtor days by requesting early payments before the financial statement date, improving liquidity.
- However, this can harm customer relationships.
Creditor Days: How Long the Business Takes to Pay Suppliers
Creditor Days
Creditor Days (also known as Payables Days) measures the average number of days a company takes to pay its suppliers after receiving goods or services.
- It helps assess cash flow management and relationships with suppliers.
Formula
$$\text{Creditor Days} = \frac{\text{Creditors} \times 365}{\text{Cost of Sales}}$$
Using the Creditor Days Ratio
- High creditor days = Better short-term liquidity but risks damaging supplier relationships.
- Low creditor days = Strong supplier relationships but possible liquidity issues.
- Compare creditor days with debtor days.
- If creditor days are longer, the business may have a stronger liquidity position.
Gearing Ratio: The Balance Between Debt and Equity
Gearing Ratio
The Gearing Ratio measures the proportion of a company’s capital that is financed through debt.
- It assesses the level of financial risk by comparing the company’s debt to its equity capital.
- A high gearing ratio indicates a higher reliance on debt, while a low ratio suggests a greater reliance on equity financing.
Formula
$$\text{Gearing Ratio} = \frac{\text{Non-Current Liabilities}}{\text{Capital Employed}} \times 100$$
Where: Capital Employed = Non-current liabilities + Equity
Students often forget to add new borrowing to both non-current liabilities and capital employed when recalculating gearing.
