Efficiency Ratio Analysis HL Unit 3.6 Source: BM Textbook by Paul Hoang

Efficiency Ratios Efficiency ratios show how well a firm’s resources have been used Additional ratios for HL: Stock turnover Debtor days Creditor days Gearing ratio

Stock Turnover Ratio This shows how many times over the business has sold the value of its stocks during the year. STOCK TURNOVER RATIO (number of times) = Cost of Goods Sold Average Stock STOCK TURNOVER RATIO (number of days) = Average stock x 365 COGS

Stock Turnover Ratio Example: COGS = $100k and Average Stock = $20k; ratio = 5 times or 73 days Explanation: The business sells all of its inventory, which is then replenished, five times a year or every 73 days on average.

Stock Turnover Ratio The higher the stock turnover the better, because money is then tied up for less time in stocks. A quicker stock turnover also means that the firm gets to make its profit on the stock quicker, and so the firm should be more competitive. However, it will vary between industries and so it is important to compare within an industry, as well as from year to year.

Debtor Days Ratio Measures the number of days it takes a firm to collect money from its debtors. Trade Debtor Collection Period = Debtors X 365 Sales Revenue A low value means that the firm is managing its debtors well. A higher value indicates that debtors are taking longer to pay. The firm would need to investigate this further.

Creditor Days Ratio Measures the number of days it takes, on average, for a business to pay its trade creditors. Trade Creditors Payment Period = Creditors x 365 COGS A longer period means that it is taking the business longer to pay its debts to its creditors. This could be an advantage (ie free credit) or indicate a problem (lack of money to make payments!). It can also prove disastrous as it may force suppliers into bankruptcy.

Gearing Ratio Is used to assess a firm’s long-term liquidity position. Gearing Ratio = Loan capital X100 Total Capital employed A higher % means that the firm must pay more interest on profits each year. Failure to do so could lead to insolvency. A lower % is preferable since shareholders will only be paid a dividend out of profits if the directors feel that the firm can afford it. Insolvency – incapacity to pay debt

Gearing Ratio Example: LT liabilities = $5 million while its capital employed = $15 million; gearing ratio = 33.3% This means that 1/3 of the firm’s sources of finance comes from external interest-bearing sources while the other 2/3 represents internal sources of finance. A firm is said to be highly geared if it has a gearing ratio of 50% and above.