Efficiency ratio analysis

Efficiency ratio analysis___Efficiency ratios are used to measure how effectively a business employs its resources...

Efficiency ratios are used to measure how effectively a business employs its resources.

Efficiency Ratio Analysis

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.

Higher creditor days means that it takes the business longer to pay for its debts, which can be a benefit, but the business needs to be careful not to damage its relations with the supplier (he might not allow credits in the future). In general, creditor days should be higher than debtor days; this will improve cash flow.

Improving creditor days

• A too high creditor days ratio may incur financial penalties.
• Negotiate with suppliers.

Debtor days

Measures the efficiency of a business’ credit control system. It gives the average number of days it takes to collect debts from customers.

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.
• 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.