Unit 3 – Finance and Accounts
3.6 – Efficiency Ratio Analysis

Efficiency Ratios are financial measurements that indicate how effectively a business manages its resources. Smart use of assets, control of receivables/payables, and sustainable funding are key to long-term financial health.

Main Efficiency Ratios & Formulas

Ratio	Formula (LaTeX style)	What it Shows
Stock Turnover	\[ \text{Stock Turnover} = \frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Stock}} \]	How many times inventory is sold or used up in a period (higher = more efficient)
Debtor Days	\[ \text{Debtor Days} = \frac{\text{Debtors}}{\text{Credit Sales}} \times 365 \]	Average days to collect payments from customers (lower = faster collection)
Creditor Days	\[ \text{Creditor Days} = \frac{\text{Creditors}}{\text{Credit Purchases}} \times 365 \]	Average days taken to pay suppliers (higher = more time to pay, but too high = risk)
Gearing Ratio	\[ \text{Gearing Ratio (\%)} = \frac{\text{Loan Capital}}{\text{Capital Employed}} \times 100 \]	Proportion of capital from debt/loans (higher = more risk from borrowing)

Understanding the Ratios

Stock Turnover:
- Retailers usually aim for high turnover to avoid waste/outdated inventory.
- Low turnover can signal overstocking or poor sales.
Debtor Days:
- Want a shorter period—shows efficient cash collection.
- High value may signal lax credit control or unreliable customers.
Creditor Days:
- A longer period means the business can conserve cash. Too long may erode supplier trust or lose discounts.
Gearing Ratio:
- A gearing ratio over 50% is often seen as “highly geared.”
- High gearing = more interest cost & risk, but possibly higher returns if the money is invested well.

Insolvency vs Bankruptcy

Insolvency occurs when a business cannot pay its debts when they are due, but hasn’t necessarily been declared ‘bankrupt.’ This is a financial state.
Bankruptcy is a legal process when a court formally declares an individual or business unable to meet financial obligations, often resulting in liquidation or restructuring.

All bankrupt companies are insolvent, but not all insolvent companies are yet bankrupt.
Businesses may try to restructure, negotiate, or raise new funds during insolvency to avoid bankruptcy.

Quick Reference Table

Ratio	Healthy Value?	What If Too High?	What If Too Low?
Stock Turnover	Varies by industry; generally higher is better	Possible stock shortages, unsatisfied customers	Inventory build-up, higher waste/storage costs
Debtor Days	Often < 45 days	Cash flow issues, bad debts increase	May indicate aggressive credit policy, risk loss of customers
Creditor Days	Between 30–60 days commonly	May strain supplier relationships, lose early-payment discounts	Not using credit advantage, tighter cash flow
Gearing	Below 50% (low-moderate risk)	Vulnerable to interest increases, repayment stress	Too little leverage—may not maximize growth potential

Key Takeaways for Students

Efficiency ratios are essential for diagnosing business health and cash management.
Formulas must always be learned in LaTeX form for exams and accurate calculations.
Ratio values vary by industry but trends, context, and year-on-year movement are most important.
Know the difference between insolvency (can’t pay now) and bankruptcy (court-declared, formal process).