3.6. Efficiency Ratio Analysis (HL only)

  • Efficiency ratio analysis

    • Looks how well a firm’s financial resources are being used.
  • Inventory/stock turnover
    • Measures the number of times a firm sells its stocks within a time period
    • Indicates the speed of selling and replenishing the stock
    • Stock turnover = (COGS / Average stock) OR (Average stock x 365) / COGs
    • Note: cost of sales (goods sold) is used rather than sales turnover since stocks are always valued at cost of purchase rather than selling price
    • Higher the ratio, the better (more profit)
    • High stock turnover ensures that perishable stocks do not expire and durable stocks do not become outdated.
    • Ways to increase stock turnover ratio
      • Holding lower levels of stock
      • Dispose of any stocks that are slow to sell
      • Reduce the range of products that are being stocked by only keeping the better selling products.
  • Debtor days
    • Debt collection period
    • Debtor days = (Debtors / Sales revenue) x 365 = in days
    • Too high: will take a lot of time before debts are fully paid
    • Too low: customers may look to other companies w/ better debt collection periods
  • Creditor days
    • Credit payment period
    • Creditor days = (Creditors / COGs) x 365
    • The longer the better (to maximize cash flow)
      • Risks late charges, bad relationship with suppliers, and legal action
  • Gearing ratio
    • Used to assess a firm’s long-term liquidity position
    • Done by examining the firm’s capital employed that is financed by long-term debts, such as mortgages and debentures
    • Represents the part of the business that came from external sources of funding
    • Gearing ratio =  (Long-term liabilities / Capital employed) x 100 OR (Loan capital / Capital employed) x 100
    • High gearing (over 50%)
      • Inadequate long-term liquidity – very risky
      • More dependency on long-term sources of borrowing
    • High gearing impact
      • More vulnerable to increases in interest rates
      • If there is recession, loan repayments are still high but sales will most probably fall
      • Financiers are less likely to lend to highly-geared firms
      • Vulnerable to rival takeovers
    • Factors that affect level of gearing
      • Size of the business
      • Level of interest rates
      • Potential profitability

 

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