Measuring Efficiency

Question 1

Efficiency Ratios

Answer 1

Efficiency ratios tend to be used to assess how well management is controlling key aspects of the business e.g. stock and finances

There are three efficiency ratios: trade receivable days, trade payable days, inventory turnover

Question 2

Trade Receivable Days

Answer 2

Trade receivable days ratio measures how long it takes for debtors to pay

It is expressed as a number of days

E.g. if a business had a debtors’ payments period of 60 days this means on average it takes debtors two months to pay for goods and services purchased on credit

Trade receivable days vary depending on nature of business and items sold and if it’s business-to-business or business-to-consumer

Question 3

Business-to-business

Answer 3

B2B refers to when one business sells to another business

E.g. a stationery business selling to a firm of accountants

Question 4

Business-to-consumer

Answer 4

B2C refers to when one business sells to an individual

E.g. a stationery business selling wedding stationery to a bride and groom

Question 5

Trade Receivable Days Formula

Answer 5

TRD = (Trade receivables / Credit sales) x 365

Question 6

Trade Payable Days

Answer 6

Trade payable days is a ratio that measures on average how long it takes a firm to pay for goods and services bought on credit

It is expressed as a number of days

E.g. If a business had trade payable days of 30 days it means on average there is a one month gap between the business buying the good or service and paying for it

Question 7

Trade Payable Days

Formula

Answer 7

TPD = (Trade Payables / Credit Purchases) x 365

Question 8

Inventory Turnover

Answer 8

Inventory turnover is a ratio that measures the average amount of time an item of stock is held by a business

It is expressed as a number of days

E.g. If a business has an inventory turnover of 7 this means that n average it holds each item of stock for one week

Question 9

Inventory Turnover Formula

Answer 9

Inventory Turnover = (Average Inventory / Cost Of Sales) x 365

Question 10

Average Inventory Formula

Answer 10

Average Inventory = Opening Inventory + Closing Inventory / 2

Question 11

Limitations Of Ratios

Answer 11

• They are calculated on past data and therefore may not be a true reflection of the business’s current performance
• Financial records may have been manipulated and therefore ratios will be based on potentially misleading data
• Ratios do not consider qualitative factors
• A ratio can indicate that there is a problem in a business but does not directly identify the cause of the problem or the solution
• Interfirm comparisons can be difficult as not all firms report their performance in the same way or generate their accounts in the same way