Strategies to Improve Efficiency Ratios
- Efficiency ratios measure how well a business manages its resources and operations.
- Improving these ratios strengthens financial performance and enhances liquidity, inventory control, and debt management.
- Efficiency ratios frequently appear in case studies.
- This is a high yield section so you're prepared to analyze trends, interpret results, and recommend improvements in your responses.
Stock Turnover: Optimizing Inventory Management
- The Stock Turnover Ratio measures how often a company sells and replaces its inventory within a given period.
- Just now, we covered how a higher stock turnover indicates efficient inventory management, while a lower ratio suggests overstocking or slow sales.
Stock Turnover Formula
$$ \text{Stock Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Stock}} $$
Strategies to Improve Stock Turnover
- Implement Just-in-Time (JIT) Inventory: Reduce stock levels by ordering materials only when needed.
- Enhance Demand Forecasting: Use data analytics to predict customer demand and adjust inventory accordingly.
- Discount Slow-Moving Stock: Offer promotions to clear outdated or excess inventory.
- A higher stock turnover ratio isn't always better.
- If stock levels are too low, the business may face shortages, leading to lost sales and dissatisfied customers.
Debtor Days: Encourage Faster Payments
- Debtor days ratio measures the average time it takes for a business to collect payments from its customers.
- A shorter period improves cash flow, while a longer period may indicate liquidity issues.
Debtor Days Formula
$$ \text{Debtor Days} = \frac{\text{Debtors} \times 365}{\text{Total Sales Revenue}} $$
Strategies to Reduce Debtor Days
- Stricter Credit Policies (credit control): Limit credit terms or require upfront deposits for new customers.
- Early Payment Discounts: Offer incentives, such as a 2% discount for payments made within 10 days.
- Automate Invoicing and Reminders: Use software to send invoices promptly and follow up on overdue payments.
Definition
Credit Control
A financial strategy used by businesses to manage customer credit, minimize bad debts, and ensure timely payments. It includes setting credit limits, monitoring receivables, and enforcing payment terms.
A software company could offer a 5% discount for payments within 15 days, reducing debtor days and improving cash flow.
Exam techniqueNot all sales are credit sales. Only credit sales should be used when calculating debtor days.
