3.6 Efficiency ratio analysis Flashcards
Efficiency ratios
efficiency ratios examine the use of an organisation’s resources in terms of its assets and liabilities.
i.e. used by managers and other decision makers to measure how well the resources of a business are used in order to generate income from the firm’s capital.
what are the four Efficiency ratios
-Stock turnover ratio (or inventory turnover ratio)
-Debtor days ratio
-Creditor days ratio
-Gearing ratio
Stock turnover ratio
an efficiency ratio that measures the number of days it takes a business to sell its stock (inventory),
i.e. how quickly the stock is sold and needs to be replenished.
why is a high rate of stock turnover ratio important for perishable goods such as milk or fresh flowers
This is because any unsold stocks cannot be stored so need to be disposed as when their sell-by date has expired.
How can a firm improve stock turnover ratio (3)
-Holding lower stock levels requires inventories to be replenished more regularly
-Disposal of stocks which are slow to sell e.x: obsolete stock
- Reduce the range of products being stocked by only keeping the best-selling products
Debtor days
The debtor days ratio is an efficiency ratio that measures the average number of days an organization takes to collect debts from its customers (as they have bought goods and services on trade credit but have yet to pay for these).
Why is a low ratio of debtor days good for a firm
This is because a low debtors day ratio shows that the firm is efficient in getting debtors to pay on time. This helps to improve the firm’s working capital cycle.
how can a firm improve their debtors day ratio (3)
-Creating incentives for customers to pay by cash rather than credit, such as giving customers a discount if they pay by cash and/or charging customers interest if they pay using credit terms.
-Shortening the credit period given to customers. For example, by reducing the credit period from 60 days to 30.
-Improved credit control by using stricter criteria for those wanting to purchase products using trade credit. For example, the business might choose to offer credit only to customers with a proven track record of having paid their invoices in a timely manner.
creditor days ratio
is an efficiency ratio that measures the average number of days an organisation takes to repay its creditors
what does a high creditors day ratio suggest (2)
-repayments are prolonged, help to free up cash in the business
-suggest a firm is taking too long to pay its trade creditors
How does a firm improve their creditors days ratio (3)
-Negotiating an extended credit period with the firm’s suppliers
-Looking for different suppliers who offer preferential trade credit agreements
-Using cash to pay for inventories (cost of sales), instead of over-relying on trade credit.
gearing ratio
is an efficiency ratio that measures the extent to which an organization is financed by external sources of finance.
i.e. it is loan capital expressed as a percentage of the firm’s total capital employed
business to improve its gearing ratio (3)
-Paying off some of the firm’s long-term liabilities (loan capital), such as making additional mortgage payments.
-Enhancing the firm’s working capital (liquidity position) by improving its stock control, giving incentives for customers to pay earlier / on time, and/or reducing the credit period given to customers. An improved working capital position (or working capital cycle) enables the business to use additional funds to pay off debts, thereby reducing its level of gearing.
-Trying to use or rely more on internal sources of finance, such as retained profits or share capital, instead of external finance (which incurs interest charges).
Insolvency
Insolvency refers to the situation where a person or a business is unable to meet their bill and other debt obligations
Situations that can cause Insolvency (5)
-A cash flow crisis caused by overspending (cash outflows) or debtors (trade customers) who are late paying.
-Loss of customers who have switched to a competitor’s good or service due to changing needs and market trends.
-Loss of an important supplier that accounts for significant cost savings.
-Financial mismanagement.
-Global and local supply chain issues that prevent the business from being able to trade.
