IB Business Management 3.6.1 Efficiency Ratios Notes

Efficiency Ratios: Measuring Business Performance

1. While profitability ratios assess how much money your business makes, efficiency ratios evaluate how well your company controls its operations.
2. These ratios focus on:
   1. Stock management: ensuring optimal inventory levels
   2. Debt settlement speed: how quickly the business repays its obligations
   3. Credit control efficiency: how long customers take to settle accounts
   4. Capital financing structure: the reliance on loan capital versus shareholder funds

Stock Turnover: How Quickly Inventory is Sold

1. It reflects the efficiency of inventory management and indicates how well the company is converting its stock into sales.

Stock Turnover Formula

$$\text{Stock Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Stock}}$$

1. Two key considerations:
   1. Cost of sales is used instead of revenue, as it reflects the actual cost of goods sold.
   2. Average stock is calculated as:

$$\text{Average Stock} = \frac{\text{Opening Stock} + \text{Closing Stock}}{2}$$

OR

Stock turnover ratio in days:

$$\text{Stock Turnover Ratio in Days} = \frac{365}{\text{Stock Turnover Ratio}}$$

Interpreting Stock Turnover

1. High turnover (e.g., fresh food retailers) suggests efficient stock movement but may lead to stock shortages.
2. Low turnover (e.g., antique shops) may indicate obsolete stock or slow sales.

Debtor Days: How Long Customers Take to Pay

1. It reflects the efficiency of the company’s credit control and collection practices.

Debtor Days Formula

$$\text{Debtor Days} = \frac{\text{Debtors} \times 365}{\text{Total Sales Revenue}}$$

Using the Debtor Days Ratio

1. Lower debtor days = Faster cash collection, better liquidity.
2. Higher debtor days = Potential cash flow problems but may attract more customers by offering longer credit terms.

Creditor Days: How Long the Business Takes to Pay Suppliers

1. It helps assess cash flow management and relationships with suppliers.

Formula

$$\text{Creditor Days} = \frac{\text{Creditors} \times 365}{\text{Cost of Sales}}$$

Using the Creditor Days Ratio

1. High creditor days = Better short-term liquidity but risks damaging supplier relationships.
2. Low creditor days = Strong supplier relationships but possible liquidity issues.

Gearing Ratio: The Balance Between Debt and Equity

1. It assesses the level of financial risk by comparing the company’s debt to its equity capital.
2. A high gearing ratio indicates a higher reliance on debt, while a low ratio suggests a greater reliance on equity financing.

Formula

$$\text{Gearing Ratio} = \frac{\text{Non-Current Liabilities}}{\text{Capital Employed}} \times 100$$