3.7 - Efficiency Ratio Analysis
The purpose and types of efficiency ratios
Efficiency ratios assess how effectively a business utilises its resources and capital to produce income. They help identify areas for improvement in resource management, which can enhance overall performance.
The main types of efficiency ratios
- Stock turnover (inventory turnover) - Measures how quickly stock is sold or replenished.
- Debtor days - Indicates the average time taken to collect payments from customers.
- Creditor days - Shows the average time taken to pay suppliers.
- Gearing ratio - Evaluates the proportion of debt in the business's financing.
How efficiency ratios are used
Management applies these ratios to boost performance, such as shortening customer collection periods or speeding up stock conversion to cash. There is often a positive link between strong efficiency ratios and higher profitability ratios, as better resource use tends to increase profits.
Stock turnover ratio
The stock turnover ratio shows either the number of times stock is replenished in a period or the days taken to sell it. It helps businesses understand inventory management efficiency.
Formula for stock turnover (number of times)
Where:
- Cost of goods sold = Total cost of items sold (£)
- Average stock = (Opening stock + Closing stock) ÷ 2 (£)
Formula for stock turnover (number of days)
Where:
- Average stock = (Opening stock + Closing stock) ÷ 2 (£)
- Cost of goods sold = Total cost of items sold (£)
Factors influencing stock turnover
Stock turnover differs across industries; for example, a supermarket has a high rate due to fast-selling items, while a high-end jewellery store has a lower rate. Businesses with perishable goods, like fruit sellers, need high turnover to avoid waste, whereas those with durable, high-margin items, such as electronics, can manage with lower rates. Service-based firms, like schools or insurers, often have little stock, making this ratio less relevant.
Ways to improve stock turnover
- Remove outdated stock - Sell off or dispose of obsolete items to free up space and capital.
- Reduce product variety - Focus on fewer items to simplify control and speed up sales.
- Adopt just-in-time systems - Order stock only when needed to minimise holding times.
Worked example - Calculating stock turnover
A business has an opening stock of £20,000 and a closing stock of £40,000. The cost of goods sold is £210,000. Calculate the stock turnover in number of times and in days.
Step 1: Identify the values
- Opening stock = £20,000
- Closing stock = £40,000
- Cost of goods sold = £210,000
Step 2: Calculate average stock
Average stock = (£20,000 + £40,000) ÷ 2 = £30,000
Step 3: Calculate stock turnover (number of times)
Step 4: Calculate stock turnover (number of days)
Debtor days ratio
The debtor days ratio calculates the average days a business waits to receive payment from customers buying on credit. A lower ratio suggests efficient collection, while a higher one may indicate rapid sales growth outpacing cash inflow.
Formula for debtor days
Where:
- Debtors = Amount owed by customers (£)
- Total sales revenue = Income from sales (£)
Ways to improve debtor days
- Provide cash incentives - Offer discounts for prompt payments to encourage quicker settlements.
- Shorten credit terms - Reduce the allowed payment period for customers.
- Enforce stricter controls - Implement rigorous checks and follow-ups on overdue accounts.
Worked example - Calculating debtor days
A company has debtors amounting to £50,000 and total sales revenue of £400,000. Calculate the debtor days ratio.
Step 1: Identify the values
- Debtors = £50,000
- Total sales revenue = £400,000
Step 2: Apply the formula
Creditor days ratio
The creditor days ratio measures the average days a business takes to pay its suppliers. Longer periods can aid cash flow if no penalties apply, but an increasing ratio might signal more credit purchases or delays. Ideally, debtor days should be shorter than creditor days. Standard credit terms are often 30-45 days, depending on the industry and location.
Formula for creditor days
Where:
- Creditors = Amount owed to suppliers (£)
- Cost of goods sold = Total cost of items sold (£)
Ways to improve creditor days
- Extend payment terms - Negotiate longer periods with suppliers without damaging relationships.
- Seek better suppliers - Switch to those offering more flexible credit options.
- Opt for cash payments - Use cash for select purchases to avoid credit dependencies.
Worked example - Calculating creditor days
A firm has creditors of £45,000 and cost of goods sold of £350,000. Calculate the creditor days ratio.
Step 1: Identify the values
- Creditors = £45,000
- Cost of goods sold = £350,000
Step 2: Apply the formula
Gearing ratio
The gearing ratio indicates the extent of debt financing by comparing loan capital to total capital employed. High gearing increases risk from interest rate rises or recessions, making the business less stable and riskier for investors. Low gearing means more reliance on internal funds, offering better protection against fluctuations. However, high gearing can be suitable in low-interest environments with growth potential, like a tech startup using loans for expansion.
Formula for gearing ratio
Where:
- Loan capital = Total borrowed funds (£)
- Capital employed = Total assets minus current liabilities (£)
Ways to improve gearing ratios
- Repay debts - Clear long-term loans to reduce dependency on borrowing.
- Enhance working capital - Improve inventory management or accelerate customer collections for better cash flow.
- Use internal sources - Rely on retained profits or issue shares for funding instead of loans.
Worked example - Calculating gearing ratio
A business has loan capital of £180,000 and capital employed of £540,000. Calculate the gearing ratio.
Step 1: Identify the values
- Loan capital = £180,000
- Capital employed = £540,000