❤️‍🔥 3.6 Efficiency ratio analysis

Efficiency ratios

Used by managers and other decision makers to measure how well the resources of a business are used to generate income from the firm’s capital.

How does ratio analysis help businesses to improve their operational efficiency?

• Debtor debts ratio: Looking at ways to reduce the time it takes the business to collect cash payments from its customers

• Stock control ratio: Improve its inventory control

• Creditor days ratio: Improve its relationship with suppliers and trade creditors

• Gearing ratio: Managing its level of affordable debt

Stock turnover ratio

Measures the number of days it takes a business to sell its stock (inventory), how quickly the stock is sold and needs to be replenished.

OR the number of times during any given period of time that a business needs to restock or replace its inventory.

Stock turnover ratio formulas

Stock turnover (number of times) = cost of sales/average stock

Stock turnover (number of days) = (average stock/cost of sales) x 365

Average stock level formula

• (Opening stock + Closing stock)/2

Ways to improve the stock turnover ratio

• Get rid of obsolete (outdated) inventory to reduce the firm’s stock levels.

• Supply a narrower range of products to simplify the amount of stocks that the firm needs to hold and control.

• Implement a just-in-time stock control system so that the firm does not need to hold any stocks.

Debtors days ratio

Measures the average number of days an organization takes to collect debts from its customers who have purchased goods and services on trade credit, but have yet to pay for these.

Debtor days ratio formula

Debtor days ratio (number of days) = (debtors/total sales revenue) x 365

Ways to improve the debtor days ratio

• Create incentives for customers to pay by cash, such as discounts or charging customers with interest if they pay using credit terms

• Shortening the credit period given to customers allows the business to receive payments from customers at an earlier date.

• Improved credit control by using stricter criteria, such as offering credit only to customers with a proven track record of having paid their invoices in a timely manner.

Creditor days ratio

Average number of days an organization takes to repay its creditors or suppliers who the business has bought products from using trade credit, but have yet to pay for these.

Creditor days formula

Creditor days (number of days) = (creditors/cost of sales) x 365

Creditor days and cash flow position

• Business that can delay making payments can improve its cash flow position. In the long-term, interest charges for late payments or imposed on the loans can be costly.

Improve its creditor days ratio

• Negotiate an extended credit period

• Look for different suppliers who offer preferential trade credit agreements.

• Using cash to pay for inventories (cost of sales), instead of over-relying on trade credit.

Gearing ratio

Indicates the degree of financial risk that a business can afford to take by measuring the extent to which the firm’s capital employed is financed by external borrowing.

Loan capital expressed as a percentage of the firm’s total capital employed.

Gearing ratio formula

Gearing ratio = (non-current liabilities/capital employed) x 100

Ways to improve the gearing ratio

• Pay off long-term liabilities.

• Enhance the firm’s liquidity position, giving incentives for customers to pay earlier/ on time and reducing credit period given to customers.

  • The business can use additional funds to pay off debts, reducing its gearing.

• Rely more on internal sources of finance,

Insolvency

Situation where a person or a business is unable to meet their bill and other debt obligations as the liabilities exceed assets.

Situations that can cause insolvency

• Cash flow crisis caused by overspending or debtors who are late paying.

• Loss of customers due to brand switching

• Loss of an important supplier that accounts for significant cost savings.

Bankruptcy (receivership or corporate liquidation)

Situation when a person or business declares that they can no longer pay back their debts, so the entity collapses. Any outstanding debts can be written off after an independent organization takes charge of legal proceedings to administer the bankruptcy.

Insolvency vs Bankruptcy

• Insolvency: state of financial distress

• Bankruptcy: legal declaration and legal processes culminating in a conclusion.

Limited liability companies and bankruptcy

• Shareholders of the company do not have to pay any of these debts as they have limited liability.

Voluntary administration

Appointment of a third party (voluntary administrator or independent registered liquidator) that takes full control of the business with the intended purpose of saving it.