3.6 Efficiency ratio analysis (HL)

Narrower range of goods (Stock turnover)

Benefits: Simplifies stock control, increases oversight, and reduces total stock quantities. Limitations: Reduces customer choice, which may lower sales revenue if customers switch to competitors.

Selling obsolete stock (Stock turnover)

Benefits: Clears out unpopular stock items to save on storage and holding costs. Limitations: May require significant discounting, reducing profit margins on those goods.

Stocking high-demand goods (Stock turnover)

Benefits: Accelerates sales rate of stock, directly boosting the stock turnover ratio. Limitations: Requires accurate forecasting; miscalculating trends can lead to overstocking.

Just-in-Time / JIT stock control (Stock turnover & Creditor days)

Benefits: Orders stock only as needed for production, eliminating excess inventory and storage costs. Limitations: High supply chain vulnerability; disruptions or delays can halt production and cause stockouts.

Having customers pay in cash (Debtor days)

Benefits: Encourages cash settlement via discounts or cash-only policies, reducing outstanding credit balances. Limitations: May alienate credit-reliant customers, leading to a potential decline in sales volume.

Shortening credit periods (Debtor days)

Benefits: Reduces credit terms (e.g., from 90 to 30 days), forcing debtors to pay faster and lowering debtor days. Limitations: Customers may switch to competitors offering more generous or flexible credit terms.

Improving credit control (Debtor days)

Benefits: Restricts trade credit to customers with proven creditworthiness, reducing default risk and late payments. Limitations: Stricter screening criteria may exclude potential new customers and reduce gross sales.

Refusing business to late payers (Debtor days)

Benefits: Halts deliveries to non-paying customers, pressuring them to clear outstanding invoices quickly. Limitations: Risks permanently damaging long-term customer relationships and losing future revenue.

Threatening legal action or penalties (Debtor days)

Benefits: Enforces payment via legal threats or interest charges on overdue amounts. Limitations: Creates an adversarial relationship and can severely damage the business's market reputation.

Negotiating longer credit periods (Creditor days)

Benefits: Keeps cash within the business longer, improving working capital and liquidity. Limitations: Can strain supplier relationships, as suppliers face their own working capital constraints.

Sourcing alternative suppliers (Creditor days)

Benefits: Allows the business to shop around for suppliers offering better credit terms or longer payment windows. Limitations: Time-consuming to establish trust, and new suppliers may initially offer worse credit terms or lower quality.

Paying off long-term liabilities (Gearing ratio)

Benefits: Directly reduces non-current liabilities, lowering interest burden and reducing the gearing ratio. Limitations: Drains cash reserves, leaving less capital available for daily operational liquidity or expansion.

Increasing retained profit (Gearing ratio)

Benefits: Boosts total equity (the denominator), lowering the gearing ratio without taking on additional debt. Limitations: Often requires cutting dividend payouts to shareholders, potentially lowering investor satisfaction.

Issuing/selling more shares (Gearing ratio)

Benefits: Raises equity capital to lower gearing without incurring interest charges or repayment obligations. Limitations: Dilutes existing ownership control and earnings per share (EPS).

Insolvency

A financial state where a business or individual is unable to meet its short-term financial obligations as they fall due.

Causes of Insolvency

Extended debtor days, sudden drop in sales revenue, uncontrolled operational costs, or major legal fees/settlements.

Bankruptcy

A legal process for an insolvent entity that allows restructuring of debts or liquidating assets to pay off creditors.

Administration / Going into administration

The legal term used in common law jurisdictions (e.g., UK, Australia) for limited liability companies undergoing insolvency restructuring.

Liquidation

The process of selling off a business's current and non-current assets to convert them into cash to settle debts with creditors.

Liquidation as a last resort

Liquidation permanently terminates the business, wipes out equity holders, and inflicts severe financial damage on stakeholders.