34.3 Financial efficiency ratios

Financial efficiency ratios (3)

1. Inventory turnover

2. Trade receivables turnover

3. Trade payables turnover

Inventory turnover

A financial efficiency ratio that records the number of times inventory is bought in and resold in a period of time.
The higher the ratio, the more efficient management is at selling inventory rapidly, whereas a lower ratio might suggest a JIT approach is needed. An increase in this ratio over time shows the business is reducing finance used to hold inventories.
It is NOT expressed as a percentage but rather shows the number of times inventory is turned over within a time period.

Formula: cost of sales / average inventory
Average inventory: (inventory at the start of the year + inventory at the end of the year) / 2

Trade receivables turnover (days)

A financial efficiency ratio that measures how long, on average, it takes a business to recover from customers who have bought goods on credit.
The shorter the time the better management is at controlling its working capital. Consequently, a higher the ratio will increase a company's working capital requirements but it might be a deliberate management strategy.
The value of this ratio could be reduced by offering shorter credit terms or by refusing to sell goods on credit to frequent late payers.

Formula: (trade receivables / credit sales) x 365

Trade payables turnover (days)

A financial efficiency ratio that records the average length a business takes to pay their suppliers. The formula can use either credit purchases or cost of goods sold.
The longer this length is, the lower working capital needs of the business will need.
A cash flow problem can occur if a business pays suppliers more quickly than it receives payment from trade receivables.

Formula: (trade payables / credit purchases) x 365

Methods of improving financial efficiency (3)

1. Increase the inventory turnover rate by adopting a JIT approach
- Demand is unpredictable, so there is a chance that the business might not be able to supply if it has no buffer inventories or low levels of it
- Delivery costs will increase as a result of frequent small purchases
- Reduction in bulk discounts

2. Reduce the credit period for customers (will reduce the debt collection period)
- Customers might switch to businesses offering longer credit periods

3. Delay payment to suppliers (increase the creditor payment period)
- Suppliers might refuse to supply materials or cease the business relationship with the company
- Discounts for quick payment will be reduced