3.6.2 Strategies to Improve Efficiency Ratios Notes

Strategies to Improve Efficiency Ratios

1. Efficiency ratios measure how well a business manages its resources and operations.
2. Improving these ratios strengthens financial performance and enhances liquidity, inventory control, and debt management.

Stock Turnover: Optimizing Inventory Management

1. The Stock Turnover Ratio measures how often a company sells and replaces its inventory within a given period.
2. Just now, we covered how a higher stock turnover indicates efficient inventory management, while a lower ratio suggests overstocking or slow sales.

Stock Turnover Formula

$$ \text{Stock Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Stock}} $$

Strategies to Improve Stock Turnover

1. Implement Just-in-Time (JIT) Inventory: Reduce stock levels by ordering materials only when needed.
2. Enhance Demand Forecasting: Use data analytics to predict customer demand and adjust inventory accordingly.
3. Discount Slow-Moving Stock: Offer promotions to clear outdated or excess inventory.

Debtor Days: Encourage Faster Payments

1. Debtor days ratio measures the average time it takes for a business to collect payments from its customers.
2. A shorter period improves cash flow, while a longer period may indicate liquidity issues.

Debtor Days Formula

$$ \text{Debtor Days} = \frac{\text{Debtors} \times 365}{\text{Total Sales Revenue}} $$

Strategies to Reduce Debtor Days

1. Stricter Credit Policies (credit control): Limit credit terms or require upfront deposits for new customers.
2. Early Payment Discounts: Offer incentives, such as a 2% discount for payments made within 10 days.
3. Automate Invoicing and Reminders: Use software to send invoices promptly and follow up on overdue payments.

Creditor Days: Balance Payment Timing

1. Creditor days ratio measures the average time a business takes to pay its suppliers.
2. A longer period can improve liquidity, but delaying payments excessively may harm supplier relationships.

Creditor Days Formula

$$ \text{Creditor Days} = \frac{\text{Creditors} \times 365}{\text{Cost of Sales}} $$

Strategies to Manage Creditor Days

1. Negotiate Extended Terms: Work with suppliers to secure longer payment periods without penalties.
2. Prioritize Key Suppliers: Pay critical suppliers on time to maintain strong relationships.
3. Align with Debtor Days: Ensure creditor days exceed debtor days to avoid cash flow gaps.

Gearing Ratio: Reduce Reliance on Debt

1. Gearing ratio measures the proportion of a business's capital that comes from long-term debt.
2. A high ratio indicates greater financial risk, while a low ratio suggests stability but may limit growth.

Formula

$$ \text{Gearing Ratio} = \frac{\text{Non-Current Liabilities}}{\text{Capital Employed}} \times 100 $$

Strategies to Improve Gearing Ratio

1. Retain Profits: Use retained earnings to fund growth instead of borrowing.
2. Issue Equity: Raise capital by selling shares, reducing reliance on debt.
3. Refinance Debt: Replace high-interest loans with lower-cost alternatives.

Balancing Improvements and Trade-Offs

1. Improving efficiency ratios often involves trade-offs.
2. Reducing debtor days by tightening credit terms could lead to lost sales if customers switch to competitors.