The meaning and importance of financial efficiency

Financial efficiency describes how well a business manages its financial resources to achieve its goals. High financial efficiency shows that managers are making good use of assets and keeping borrowing to a minimum, which helps lower the costs associated with financing.

The three main financial efficiency ratios are:

1. Rate of inventory turnover
2. Trade receivables turnover
3. Trade payables turnover

The rate of inventory turnover

The rate of inventory turnover measures how many times a business buys and resells its inventory over a specific period. Keeping less capital locked in inventory improves financial efficiency.

Formula for the rate of inventory turnover

$\text{Rate of inventory turnover}=\frac{\text{cost of sales}}{\text{average inventory}}$

Where:

• Cost of sales = Total cost of goods sold during the period (£)
• Average inventory = (inventory at start of year + inventory at end of year) / 2 (£)

Interpreting the rate of inventory turnover

• The result shows the number of times inventory is turned over in a year, not a percentage.
• Higher figures suggest more effective inventory control.
• Approaches like just-in-time (JIT) inventory management can lead to very high turnover rates.
• Typical results vary by sector; for example, a supermarket might have a much higher rate than a high-end furniture retailer.
• This ratio has limited use for service-based businesses that do not deal in physical goods.

Worked example - Calculating the rate of inventory turnover

A business has a cost of sales of £520,000. Inventory at the start of the year is £70,000, and at the end of the year, it is £90,000. Calculate the rate of inventory turnover.

Step 1: Identify the values

• Cost of sales = £520,000
• Inventory at start of year = £70,000
• Inventory at end of year = £90,000

Step 2: Calculate average inventory

$\text{Average inventory}=\frac{\pounds \mathrm{70,000}+\pounds \mathrm{90,000}}{2}=\pounds \mathrm{80,000}$

Step 3: Apply the formula

$\text{Rate of inventory turnover}=\frac{\pounds \mathrm{520,000}}{\pounds \mathrm{80,000}}=6.5\text{ times}$

Step 4: Interpretation

This means the business turns over its inventory about 6.5 times per year, indicating moderate efficiency depending on the industry.

Trade receivables turnover

Trade receivables turnover (days) calculates the average time it takes for a business to collect payments from customers who purchased on credit.

Formula for trade receivables turnover

$\text{Trade receivables turnover (days)}=\frac{\text{trade receivables}}{\text{credit sales}}\times 365$

Where:

• Trade receivables = Amount owed by customers (£)
• Credit sales = Total sales made on credit during the period (£)

Interpreting trade receivables turnover

• Shorter times reflect stronger management of working capital.
• There is no standard ideal figure, as it differs across industries and businesses.
• Longer periods might be a planned approach to draw in customers with generous credit options.
• Longer periods could also signal weak credit control practices.
• Businesses can shorten this by reducing credit periods or enhancing credit monitoring.

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Worked example - Calculating trade receivables turnover

A business has trade receivables of £35,000 and credit sales of £280,000 for the year. Calculate the trade receivables turnover in days.

Step 1: Identify the values

• Trade receivables = £35,000
• Credit sales = £280,000

Step 2: Apply the formula

$\text{Trade receivables turnover (days)}=\frac{\pounds \mathrm{35,000}}{\pounds \mathrm{280,000}}\times 365=45.63\text{ days}$

Step 3: Interpretation

This indicates the business takes about 46 days on average to collect payments, which may be efficient or not depending on industry norms.

Trade payables turnover

Trade payables turnover (days) assesses the average time a business takes to settle payments with its suppliers.

Formula for trade payables turnover

$\text{Trade payables turnover (days)}=\frac{\text{trade payables}}{\text{credit purchases}}\times 365$

Where:

• Trade payables = Amount owed to suppliers (£)
• Credit purchases = Total purchases made on credit during the period (£)

Interpreting trade payables turnover

• Longer times help decrease the need for working capital.
• Settling with suppliers faster than collecting from customers can cause cash flow issues.
• This situation often requires extra financing for working capital.

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Worked example - Calculating trade payables turnover

A business has trade payables of £60,000 and credit purchases of £320,000 for the year. Calculate the trade payables turnover in days.

Step 1: Identify the values

• Trade payables = £60,000
• Credit purchases = £320,000

Step 2: Apply the formula

$\text{Trade payables turnover (days)}=\frac{\pounds \mathrm{60,000}}{\pounds \mathrm{320,000}}\times 365=68.44\text{ days}$

Step 3: Interpretation

This means the business takes about 68 days on average to pay suppliers, which could help with cash flow but might strain supplier relationships.

Methods to improve financial efficiency

Businesses can take various steps to boost financial efficiency, though each comes with potential downsides.

Strategies for enhancing financial efficiency

• Boost inventory turnover through JIT management - This reduces capital tied up in stock but risks interruptions from supply chain issues.
• Shorten credit terms for customers - This speeds up cash inflows but may lead to customers choosing rivals with better terms.
• Extend payment times to suppliers - This preserves cash but could result in missing discounts for early payment or harming ties with suppliers.