3.6 Efficiency Ratios analysis

Stock turnover ratio definition

Efficiency ratio that measures the number of days it takes a business to sell its stock (inventory where stock is a current asset.

• Shows the number of times during a period of time (usually a year) that the business needs to restock or replace its inventory.

Formula for Stock turnover ratio

stock turnover (number of times) = Cost of sales / average stock

stock turnvoer (number of days) = Average stock/ cost of sales x 365

• Cost of sales (retailing) = cost of goods sold

  • Amount of money firm x spend on stock from suppliers

  • Opening stock value $ + all purchases of stock in year x - closing value

• Average stock

  • Value of inventory

  • Opening stock + closing stock /2

Factors that affect stock turnover

1. Perishability = perishable products and the number of times per year is low = concern, typically very high

2. Price = high involvement products (HIP) : customers spend a lot of time and effort considering the product vs low involvement products (LIPS) have higher stock turnovers

Strategies to improve stock turnover

• Lower stock level requires more inventories to be replenished more regularly.

• Divestment of stocks which are unpopular or slow to sell

  • Promotion strategies to encourage people to buy them

  • marketing to broader age groups

  • Change the price - discounts

• Reduce the range of products being stocked by only keeping the best selling products

  • Contribution analysis - finding the products that contribute the least to overall profits

Debtor Days ratio definition

An efficiency ratio that measures the average number of days it takes a business to collect money from its debtors - From its customers (who have bought goos and services on trade credit)

Debtors definition

• Customers

benchmark for creditor days

30-60 days

• Generally, lower creditor days better

  • avoid penalties for late payments to trade creditors

• ratio that is too high may be beneficial or problematic

  • High creditor days ratio means repayment is prolonged - free up cash to be used elsewhere

  • Also mean that the firm is taking to long to pay its creditors so they might face financial penalties for late payment

Gearing ratio Definition

Efficiency ratio used to assess a firms long-term liquidity position. This is done by examining the firms capital employed that is financed by non-current liabilities such as mortgages and debentures.

Gearing ratio formula

Non-current liabilities / capital employed x 100

• Capital employed = non-current liabilities + equity + loan capital

  • Also called share capital, accumulated retained profit or money used

• Non-current liability = long term debt

  • Loan capital examples

    • mortgage

    • Debenture

    • bank loan

benchmark gearing ratio

Highly geared if gearing ratio is 50% or above

• Firms are vulnerable to changes in interest rates as they will have to pay more in interest

• When highly geared it is difficult to seek future external sources of finacne as lenders are concerned about the risks of default by highly geared firms

Level of gearing that is acceptable depends on:

• Size and status of the business ( bigger the business the higher gearing ratio) - more likely for a greater percentage of money on hand is borrowed

• Level of interest rates in the economy

• Potential profitability

Strategies to improve the gearing ratios

• Develop closer relationships with customers to reduce the debt collection time

• Develop closer relationships with creditors and suppliers to extend credit periods

• Introduce a system of just-in time production to eliminate the need to hold large amounts of stock

• Improve credit control