Unit 3.6 : Efficiency Ratios Flashcards
1
Q
Efficiency Ratios
A
- Efficiency Ratios show how well a firm’s resources have been used, such as the amount of time taken by the firm to sell its stock or the average number of days taken to collect money from its debtors
2
Q
Four HL efficiency ratios
A
- Stock turnover
- Debtor Days
- Creditor Days
- Gearing ratio
3
Q
Stock turnover
A
- The stock turnover ratio or inventory turnover ratio
- It measures the number of times a firm sells its stocks within a time period, usually one year
- The ratio therefore indicates the speed at which a firm sells and replenishes all its stock
- When looking at stock turnover, COGS is used (rather than sales turnover) as stocks are valued at cost value of the inventory rather than selling price
- e.g. a restaurant should expect a significantly higher turnover rate than luxury motor vehicles
- A low turnover rate is not necessarily a bad sign, it should just be put into context
4
Q
Stock turnover equation
A
Stock turnover (number of times) = Cost of goods sold/Average stock
Stock Turnover (number of days) = Average stock/COGS * 365
5
Q
How to improve stock turnover ratio
A
- Holding lower stock levels requires inventories to be replenished more regularly
- Divestment or disposal of stocks which are slow to sell (getting rid of obsolete or unpopular products)
- Reduce the range of products being stocked by only keeping the best-selling products
6
Q
Debtor days
A
- Debtor days ratio measures the number of days it takes a firm, on average, to collect money from its debtors
- It’s sometime referred to as the debt collection period
- Debtors are the customers who have purchased items on trade credit and therefore owe money to the firm
- The less time it takes for customers to pay their debts, the better for the business as it improves the cash flow is and the business could also invest the money into over revenue-generating projects
- It is quite common to allow customers 30-60 days trade credit
7
Q
Debtor days formula
A
Debtor days = Debtors/Sales Revenue * 365
8
Q
Problem with a too high or too low debtor days
A
- Although firms may allow customers to buy on credit, it is important that the credit period granted is not too long or the business can face liquidity problems
- A too low ratio suggest customers may seek other suppliers if the credit period given to them is uncompetitive because clients prefer better credit terms
9
Q
Credit control
A
- Ability of a firm to collect debts within a suitable timeframe is known as credit control
- A business is generally seen as having good credit control if it can collect debts within 30-60 days
10
Q
How to improve debt collection period
A
- Impose surcharges on late payers (e.g. banks add a fine to those who pay their bills late)
- Give debtors incentives to pay earlier, such as giving a discount to those who pay their bills before the due date
- Refuse any further business with a client until payment is made
- Threaten legal action (this is rather extreme but is often used for clients who repeatedly pay late
11
Q
Creditor Days
A
- Creditor days ratio measures the number of days it takes, on average, for a business to pay its trade creditors
- It is common to provide customers with 30-60 days credit, so a creditor days ratio in this range would seem acceptable
- A high creditor days ratio means that repayments are prolonged which can help to free up cash in the business but it can also mean that the business is taking too long to pay its creditors so suppliers may impose financial penalties for late payment
12
Q
Creditor days equation
A
Creditor days = Creditors / COGS * 365
13
Q
How to increase creditor days
A
- Developing closer relationships with customers, suppliers, and creditors, thereby helping to reduce the debt collection time and extend credit period
- Introduce a system of just-in-time production to eliminate the need to hold large amounts of stock and to improve stock control
- Improve credit control such as by giving customers an incentive to pay earlier or on time helps to reduce the chances of bad debts
14
Q
Gearing ratio
A
- The gearing ratio is used to assess a firm’s long-term liquidity position by examining the firm’s capital employed that is financed by long-term debt, such as mortgages and debentures
- Gearing enables managers to gauge the level of efficiency in the use of a firm’s capital structure
- If a business has a gearing ratio of 33%, then one third of the firm’s sources of finance comes from external interest-bearing sources, whilst the other two-thirds represent internal sources of finance
- The higher the gearing ratio, the larger the firm’s dependence on long-term sources of borrowing which means that the firm incurs higher costs due to debt financing, such as interest repayments to banks or debenture holders which will limit the net profit for the firm
- A firm is said to be highly geared if it has a gearing ratio of 50% or above (but remember firms may take out huge loans for expansion)
- Firms that are highly geared may have some people reluctant to lend more money and are also more exposed to risk (interest rate or economy)
15
Q
Capital employed formula
A
Capital employed = loan capital (long-term liabilities) + share capital + retained profit
