Efficiency Ratios: Measuring Business Performance
- While profitability ratios assess how much money your business makes, efficiency ratios evaluate how well your company controls its operations.
- These ratios focus on:
- Stock management: ensuring optimal inventory levels
- Debt settlement speed: how quickly the business repays its obligations
- Credit control efficiency: how long customers take to settle accounts
- Capital financing structure: the reliance on loan capital versus shareholder funds
- Efficiency ratios often appear in case studies.
- Keep in your back pocket the common ways of interpreting them and recommend improvements.
Stock Turnover: How Quickly Inventory is Sold
Definition
Stock Turnover Ratio
The Stock Turnover Ratio measures how often a company sells and replaces its inventory within a given period.
- It reflects the efficiency of inventory management and indicates how well the company is converting its stock into sales.
Stock Turnover Formula
$$\text{Stock Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Stock}}$$
- Two key considerations:
- Cost of sales is used instead of revenue, as it reflects the actual cost of goods sold.
- Average stock is calculated as:
$$\text{Average Stock} = \frac{\text{Opening Stock} + \text{Closing Stock}}{2}$$
OR
Stock turnover ratio in days:
$$\text{Stock Turnover Ratio in Days} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} \times 365 \text{ days}$$
NoteThis ratio is expressed as the number of times inventory is sold and replaced in a given period.
Common Mistake- Many students confuse stock turnover with revenue.
- Remember, it focuses on inventory movement, not sales.
Interpreting Stock Turnover
- High turnover (e.g., fresh food retailers) suggests efficient stock movement but may lead to stock shortages.
- Low turnover (e.g., antique shops) may indicate obsolete stock or slow sales.
