F5 - Measuring efficiency

What are efficiency ratios used for?

• Efficiency ratios assess the internal management of the business i.e. how efficient are managers in controlling the current assets.

• Efficiency ratios look at the management of cash and assets.

What is trade receivable days?

How might it be improved?

• A measure of how long it takes, on average for customers to pay the business for goods and services it has purchased on credit.

• The customer is a debtor of the business.

• A business may try to have a shorter trade receivables days to ease cash flow problems.

• A business may offer incentives for quick payment.

• Longer payment terms may be offered to increase competitiveness.

How is trade receivable days calculated?

• (Trade receivables / Credit sales) X 365

• (TR / CS) X 365

What is Trade payable days?

How might it be improved?

• A measure of how long it takes on average for the business to pay for supplies it has purchased on credit.

• A business may try to have a longer trade payables days/credit period to ease cash flow problems.

• A shorter payables days may result in discounts from suppliers.

• A business slow to pay its creditors might gain a bad reputation.

How is Trade payable days calculated?

• (Trade payable / credit purchases) X 365

• (TP / CP) X 365

What is inventory turnover?

• Measures how frequently a business turns over its inventory in a year.

• Will vary depending upon the nature of the firm.

• Hot dog stand - hopefully daily

• Fashion retailer - at least each season

• New car showroom - maybe twice a year.

• Average inventory held can be calculated by finding the average inventory at the start and end of the year.

• You therefore also need the previous year’s statement of financial position.

How do you calculate average inventory?

• Opening inventory + closing inventory / 2

• OI + CI / 2

How do you calculate inventory turnover?

• Average inventory / cost of sales X 365

• AI / COS X 365

What can a high and low turnover rate mean?

• A low turnover rate may mean that the firm holds too much stock or that stock is outdated.

• A high turnover rate may mean that the firm holds too little stock leading to a loss of sales.

• Consider the industry that the business operates in - supermarkets sell fast moving goods whilst car dealers have lower stock turnover.