Efficiency ratios are used to measure how effectively a business employs its resources.
Efficiency Ratio Analysis: Maximizing Business Resources
Efficiency ratios are vital indicators that measure how effectively a business employs its resources to generate income. These ratios are crucial for IB Business Management students to understand, as they reflect a company's operational performance.
What Are Efficiency Ratios?
Efficiency ratios, also known as activity ratios, assess the effectiveness of a company's use of its assets and liabilities. They are used to analyze various operational aspects such as inventory management, accounts receivable, and accounts payable.
Calculating Efficiency Ratios for the IB Exam
When presenting efficiency ratios in an IB exam, students should be prepared to calculate and interpret different types of efficiency ratios using financial data provided in the exam questions.
Real-Life Examples
Here are five examples of efficiency ratios in different industries:
Example 1: Inventory Turnover Ratio
This ratio measures how many times a company's inventory is sold and replaced over a period. A higher ratio indicates efficient inventory management.
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Example 2: Receivables Turnover Ratio
This ratio shows how efficiently a company collects cash from its customers. A higher ratio suggests quick collection of receivables.
Formula: Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Example 3: Payables Turnover Ratio
This ratio indicates how fast a company pays its suppliers. A higher ratio means the company pays its suppliers quickly.
Formula: Payables Turnover Ratio = Cost of Goods Sold / Average Accounts Payable
Example 4: Asset Turnover Ratio
This ratio assesses how effectively a company uses its assets to generate sales. A higher ratio means better utilization of assets.
Formula: Asset Turnover Ratio = Net Sales / Average Total Assets
Example 5: Fixed Asset Turnover Ratio
This ratio compares sales to fixed assets. A higher ratio indicates that the company is effectively using its fixed assets to generate sales.
Formula: Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets
Stock turnover
Measures how quickly a business uses or sells its stock. It is generally considered desirable to sell stock as quickly as possible and we assess it by calculating how many days it takes the business to sell the stock.
The number we get will be in days. Higher stock turnover means that profit on the sale of stock is earned more quickly, which allows these businesses to operate on lower profit margins. Lower stock turnover might be due to piling up of stock, slow moving stock, a lack of control over purchasing etc.
Improving stock turnover
- Holding lower stock levels, to replenish it more often.
- Divestment (disposal) of stocks which are slow to sell i.e getting rid of obsolete stock.
- Reducing the range of products being stocked by only keeping the best selling products.
Creditor days
This ratio measures how quickly a business pays its debts to its suppliers and other short term creditors.
Improving creditor days
- A too high creditor days ratio may incur financial penalties.
- Negotiate with suppliers.
Debtor days
The debtor days ratio should be as low as possible, as this would mean that it takes the business a very short period of time to collect its debts.
Improving debt collection
- Impose surcharges on late payers.
- Give debtors incentives to pay earlier such as giving a discount to those who pay their bills before the due date. Many firms may encourage direct debit or autopay to ensure that deadlines aren’t forgotten.
- Refuse any further business with clients until payment is made.
- Threaten legal action, extreme but effective for common late payers.
Gearing ratio
The gearing ratio shows the relationship between the loan capital and share capital of the business. In other words, how much the company relies on internal and external sources of business when it comes to choosing the source of finance to invest in the business.
If this ratio is high, we say that the company is high geared, which means that the business relies much more on loan capital than share capital when it comes to investing. When the number is low, we say that the company is low geared and it relies on share capital much more.
Improving gearing ratio
- A too high or too low gearing ratio is not good, it needs to be somewhere in between.
- For higher GR: depend on external sources of finance.
- For lower: repay creditors.
Advantages
- The burden of loan repayments is reduced (the business does not need to pay interest, because it is using share capital more).
- Volatile interest rates are not a problem anymore (if the interest rates increase, there is no issue as the business does not rely on loans that much.
- Ownership not diluted.
- Once loans have been repaid, the company’s debt is much reduced (this is because dividends are signed off whenever there is profit).
Disadvantages
- Dividend payments have to be met indefinitely (which might not be such a big disadvantage, as the shareholders can agree on lower dividends in order to increase retained profits and thus offer more investment in the business if it proves to be quite profitable).
- Ownership of the company can be diluted (selling shares puts the company at risk of being bought by an external party).
- Interest payments need to be met.
- Changing (volatile) interest rates can cause the repayments to increase, worsening the financial situation of the company, causing insolvency).
