3.6 Efficiency Ratio Analysis

Revision Notes: 3.6 Efficiency Ratio Analysis

Introduction to Efficiency Ratios

Efficiency ratios measure how effectively a business manages its resources and obligations in day-to-day operations. They focus on how quickly stock is sold, how fast cash is collected from customers, how long a business takes to pay its suppliers, and how reliant the business is on external debt. These ratios help evaluate financial health, operational discipline, and long-term stability.

Key ratios studied in this chapter:

1. Stock Turnover
2. Debtor Days
3. Creditor Days
4. Gearing Ratio

Additionally, the chapter explains the difference between insolvency (a financial condition) and bankruptcy (a legal process).

• Stock Turnover

• Definition: Shows how many times a company sells and replaces its inventory within a specific period, usually a year.

• Formula:
  Stock Turnover = Cost of Goods Sold ÷ Average Stock
  OR
  Stock Turnover (days) = (Average Stock ÷ Cost of Goods Sold) × 365

• Benchmark: Higher turnover is usually better, but it depends on the industry.

• Perishable goods (e.g., bakeries, seafood wholesalers) require very high turnover.

• Durable goods (e.g., luxury yachts) naturally have slower turnover.

• Example:

• Pharmacy A: Stock turnover = 5 times (every 73 days)

• Pharmacy B: Stock turnover = 6 times (every 61 days)

• Interpretation: Pharmacy B is more efficient in converting stock into revenue.

• Strategies to Improve Stock Turnover:

• Maintain lower stock levels to increase replenishment frequency.

• Dispose of unpopular or outdated stock.

• Narrow the product range to focus on high-demand items.

• Adopt just-in-time (JIT) systems to minimize storage costs.

• Limitations:

• Too little stock risks shortages.

• Over-focus on turnover may hurt customer service if products are unavailable.

• Debtor Days

• Definition: Measures the average number of days customers take to pay for goods bought on credit.

• Formula:
  Debtor Days = (Debtors ÷ Sales Revenue) × 365

• Benchmark: A healthy range is 30–60 days.

• Too long → liquidity problems.

• Too short → customers may prefer competitors with better credit terms.

• Example:

• Pharmacy A: 15 days → Quick collection, strong liquidity.

• Pharmacy B: 73 days → Slow collection, risk of liquidity crisis.

• Strategies to Improve Debtor Days:

• Offer early payment discounts.

• Charge penalties for late payments.

• Refuse additional sales until debts are cleared.

• Take legal action against chronic defaulters.

• Limitations:

• Shorter credit terms may push customers to competitors.

• Legal action is costly and may damage relationships.

• Creditor Days

• Definition: Average number of days a business takes to pay its suppliers.

• Formula:
  Creditor Days = (Creditors ÷ Cost of Goods Sold) × 365

• Benchmark: Typically 30–60 days.

• Short creditor days = prompt payment, stronger supplier relations.

• Long creditor days = more working capital available but may risk penalties or supply disruptions.

• Example:

• Pharmacy A: 28 days → Efficient, pays suppliers promptly.

• Pharmacy B: 97 days → Very long delays, risk of penalties or refusal of supply.

• Strategies to Improve Creditor Days:

• Improve debtor collections (cash inflow helps pay creditors).

• Negotiate longer trade credit with suppliers.

• Manage working capital more effectively.

• Limitations:

• Negotiating longer credit may harm supplier trust.

• Paying late may incur financial penalties or damage reputation.

• Gearing Ratio

• Definition: Measures the proportion of long-term financing provided by debt compared to equity. Indicates financial risk.

• Formula:
  Gearing Ratio = (Non-current Liabilities ÷ Capital Employed) × 100

• Benchmark:

• Below 50% → Low geared (safer, less risky).

• Above 50% → Highly geared (more vulnerable to interest rate changes).

• Example:

• Pharmacy A: 34% → Moderately geared, financially stable.

• Pharmacy B: 61% → Highly geared, higher risk.

• Strategies to Improve Gearing Ratio:

• Reduce reliance on debt (e.g., repay loans, avoid new borrowings).

• Increase retained earnings (reinvest profits).

• Raise capital through issuing shares.

• Improve efficiency in stock, debtors, and creditors to reduce need for debt financing.

• Limitations:

• Reducing debt may limit growth opportunities.

• Issuing new shares can dilute ownership.

Insolvency vs Bankruptcy

• Insolvency:

• When a business cannot meet its financial obligations on time due to cash shortages.

• Causes: poor cash flow (inflow < outflow), excessive debts, poor working capital management.

• Can often be corrected through restructuring, asset sales, or improved credit management.

• Bankruptcy:

• A legal state declared when a business is unable to repay debts, even after selling assets.

• It is the final step after insolvency cannot be resolved.

• Consequences: business closure, liquidation of assets, damaged credit rating for years.

Key Takeaways

• Stock Turnover → Efficiency in selling inventory.

• Debtor Days → Efficiency in collecting payments.

• Creditor Days → Efficiency in paying suppliers.

• Gearing Ratio → Long-term financial risk.

• Insolvency = cash problems, reversible.

• Bankruptcy = legal declaration, irreversible failure.