3.6 - Efficiency Ratio Analysis HL

Question 1

Define stock turnover

Answer 1

measures how quickly and often the stock of a firm is sold and replaced over a period of time. It could be calculated as the number of times the stock is sold or the number of days it takes to sell the stock .

Question 2

State the stock turnover ration (number of times) equation

Answer 2

Stock turnover ratio (number of times) = cost of goods sold/average costs

Question 3

State the stock turnover ratio (number of days) equation

Answer 3

Stock turnover ratio (number of days) = average costs/ costs of goods sold X 365

Question 4

Equation for average costs

Answer 4

Average costs = (opening stock+closing stock)/2

Question 5

Solve :

a firm has a COGS of £100,000 and an average stock level valued at £20,000; the stock turnover ratio is 5 times a year or every 73 days.

And analyse

Answer 5

This means that the firm sells all its inventory (stock) and then is replaced 5 times a year (specifically every 73 days).
•The higher the ratio the better is for the firm since that means that more stock is been sold and hence replaced.
• Therefore , the firm is more efficient in generating profits
•Of course it depends on the type of business, a supermarket or a restaurant have a very high stock turnover compared to a seller of luxury cars. Hence, a low stock turnover is not always a bad thing.

Question 6

What factors affect in a business affect a stock turnover

Answer 6

•Some businesses have to hold large quantities and value of stock to meet customer needs. They may have to stock a wide range of product types, brands, sizes, etc.
•Stock levels can vary during the year, often caused by seasonal demand
•Some products and industries necessarily have very high levels of stock turnover. (i.e. Fast-food outlets turnover their stocks over several times each week, let alone 8-10 times per year! And distributor of industrial products might aim to turn stocks over 10—20 times per year

Question 7

How does selling of or disposing of slow moving or obsolete stock improve the stock turnover ratio

Answer 7

This will reduce the firms’ level of stock but this can also generate loss of sales revenue that the items (stock) would have generated

Question 8

How does the introduction of innovative production techniques to reduce stock holdings improve the stock turnover

Answer 8

This will generate less stock but can be very costly

Question 9

How does rationalising the product range made or sold to reduce stock-holding requirements improve the stock turnover ratio

Answer 9

This means narrow the products to only the most demanded ones. But this might not be popular with the customers

Question 10

How does negotiating sale or return arrangements with suppliers (just-in-time) JTI I,prove the stock turnover ratio

Answer 10

With this the stock is only paid for when a customer buys it (i.e. raw material are ordered when they are needed)

Question 11

Define debtors days ratio

Answer 11

this ratio is also know as “debt collection period” and it measures the number of days it takes a firm to collect its debt from customers (debtors) who purchased merchandise on credit. Basically, tells us how efficient the business is on collecting its credit control systems

Question 12

State the debtors days ratio (number of days) equation

Answer 12

Debtors days ratio (number of days) = debtors(£) / total sales revenue X 365

Question 13

Solve and analyse:

a firm has an owed debt of £ 1 million (this is shown in the Balance Sheet) and its total sales revenue is £5 million, the ratio will be 73 days. Hence, it takes the firm 73 days to collect the debt generated by the costumers that have bought items on credit.

Answer 13

•In this case, logically, a lower ratio is better. Since the less time it takes a firm to collect debt the better. Therefore, the firm will improve their cash and also the firm could also invest this money on other projects.
•It is important that if a firm granted credit, the period for paying the debt is not too long or the firm can face liquidity problems

•The average time taken by customers to pay their bills varies from industry to industry, although it is a common complaint that trade debtors take too long to pay in nearly every market.
•If the ratio is too low (meaning that creditor does not have much time to pay back) that might lead the customer to look for alternatives and switch to another firm that might provide a better deal). The common credit time is between 30 to 60 days but it could last as many as 120 days.
•A business can determine through its terms and conditions of sale how long customers are officially allowed to take

Question 14

How does proving a discount improve debtor days ratio

Answer 14

This is aimed for customers to pay their debts earlier. However, the firm will receive less income from those customers

Question 15

How does Imposing penalties for late payers I,prove the debtors days ratio

Answer 15

This could be in the form of fines but might affect loyal customers and my turn the away

Question 16

How does stopping transactions with overdue payers improve debtors days ratio

Answer 16

Until they pay their debts. Nevertheless, this won’t guaranty the payment

Question 17

How does taking legal action improve the debtors days ratio

Answer 17

Take customers to court might affect the reputation of the business dealing with customers

Question 18

Define the creditors days ratio

Answer 18

this ratio measures the number of days a firm takes to pay its creditors. Assessing how quickly a firm is able to pay its suppliers, normally within a year.

Question 19

State the equation for creditors days ratio (number of days)

Answer 19

creditors days ratio (number of days) = creditors (£)/COGS X 365

Question 20

Analyse and solve :

a firm owes £225,000 to its suppliers (this is shown in the Balance Sheet) with £2 million worth of Cost of goods sold (COGS) , the creditors days ratio is 41 days. Therefore, a firm will take on average 41 days to pay tis suppliers.

Answer 20

• The range of 30 to 60 days is an acceptable ratio since it is common to give the costumers that time to pay.
  •In this case ideally we need a low ratio, so the firms credits will be paid sooner rather than latter
  -It could be argued that a firm that wants to maximise its cash flow should take as long as possible to pay its bills. However, there are obvious risks associated with taking more time than is permitted by the terms of trade with the supplier. One is the loss of supplier goodwill; another is the potential threat of legal action or late-payment charges.
  •It can also be argued that it is ethical to pay suppliers on time, particularly if your suppliers are much smaller and rely on timely payment of their invoices in order to manage their own cash flow.
  •Also, if the stakeholders notice that a firm is not paying its debts they might assume the business is in trouble

Question 21

How does creating a good relationship with creditors improve the creditors days ratio

Answer 21

This might enable the firm to negotiate extended credit period. However, not all the suppliers will agree to do this and that might affect the firm in the future.

Question 22

How does effective credit control improve the creditors days ratio

Answer 22

Managers need to assess the risk of paying earlier or delay the payment. This is not an easy task as it will depend on the cash-flow of the firm.

Question 23

Define gearing ratio

Answer 23

this ratio measures the extent to which the capital employed by a firm is financed from loan capital. More specifically, how a business is financed!

Question 24

State the equation for gearing ratio

Answer 24

Gearing ratio = loan capital (or long term liabilities)/capital employed X 100

Question 25

State the equation for capital employed

Answer 25

Capital employed = loan capital (or long term liabilities) + shared capital + retained profit

Question 26

Solve and analyse:

a firm has a loan capital of £5 million and a capital employed of £15 million; the gearing ratio will be 33.33%. This means that one third of the firms sources come from and external (interest baring) source and the other two thirds will represent the internal source of finance for the firm.

Answer 26

• A firm with a gearing ratio of more than 50% is traditionally said to be “highly geared”. Meaning that the business depends highly on its long term debt incurring in costs such as interest payments, which will inevitably affect the net profits. Additionally, the firm can face increases in interest rates and hence increase its debt.
• A firm with gearing of less than 25% is traditionally described as having “low gearing”
  •Something between 25% - 50% would be considered normal for a well-established business which is happy to finance its activities using debt.
  •It is important to remember that financing a business through long-term debt is not necessarily a bad thing! Long-term debt is normally cheap, and it reduces the amount that shareholders have to invest in the business.
  •The phrase “you need money to make money” implies that external financing can help a business to grow

Question 27

What are strategies to increase gearing

Answer 27

• invest in revenue growth rather than profit
• seek alternative ways or finance (ie. Covert short term loans into long term ones)
• buy more shares
• pay increase dividends out of retained profits

Question 28

What are ways to reduce (improve) gearing

Answer 28

• Minimise costs to focus on profit improvement
• Repay long-term loans
• issue more shares
• retain profits rather than pay dividends
• convert loans into liquidity