efficiency ratios

What are Efficiency Ratios?

Financial efficiency ratios analyze how effectively a business is managing its assets.

What are the three most commonly used efficiency ratios?

Inventory Turnover, Payables Days, Receivables Days.

What does Inventory Turnover measure?

Measures how often each year a business sells and replaces its inventory.

What does Payables Days measure?

Measures the average length of time taken by a business to pay amounts it owes.

What does Receivables Days measure?

Measures the average length of time taken by customers to pay amounts owed.

How is Inventory Turnover calculated?

Inventory turnover = Cost of sales ÷ Inventories

What is the inventory turnover for Rolls Royce plc this year if Cost of Sales = £10,459 million and Inventory = £2,637 million?

Inventory turnover = 10,459 ÷ 2,637 = 4.0 times

What is the inventory turnover for Tesco plc this year if Cost of Sales = £51,579 million and Inventory = £2,430 million?

Inventory turnover = 51,579 ÷ 2,430 = 21.2 times

Why might inventory turnover vary across industries?

Engineering and construction have low turnover; retail and fast-food have high turnover; seasonal fluctuations also affect turnover.

How can a business increase its inventory turnover?

Sell or dispose of slow-moving stock, introduce lean production, rationalize product range, negotiate supplier arrangements.

How are Payables Days calculated?

Payables Days = (Trade payables ÷ Cost of sales) × 365

How are Receivables Days calculated?

Receivables Days = (Trade receivables ÷ Revenue) × 365

What do Payables and Receivables Days measure?

How quickly payments are made to creditors (payables) and received from customers (receivables).

If trade receivables = £25,000, revenue = £150,000, what is the Debtor (Receivables) Days?

Debtor days = (25,000 ÷ 150,000) × 365 = 60.8 days

If trade payables = £75,000, cost of sales = £500,000, what is the Payables Days?

Payables days = (75,000 ÷ 500,000) × 365 = 54.7 days

What does a higher Receivables Days number indicate?

It shows average time customers take to pay; higher numbers may indicate slower payments.

What does a higher Payables Days number indicate?

In general, a higher figure is better for cash flow but could signal liquidity problems.

What should you watch out for when interpreting Receivables Days?

Look for comparisons with competitors and beware of balance sheet window-dressing.

What should you watch out for when interpreting Payables Days?

Look for evidence of problems paying creditors and beware of balance sheet window-dressing/manipulation.