Efficiency Ratios

Efficiency Ratios

Efficiency ratios evaluate how well a firm’s financial resources are being used. There are four main efficiency ratios: stock turnover, return on capital employed, debtor days and creditor days. 

Stock Turnover Ratio

Stock turnover ratios measures the number of times a firm sells its stocks within a time period (usually 1 year). The ratio therefore indicates the speed at which the firm empties and replenishes its stock. The higher ratio is better because more stock I sold and therefore the more profit the firm is more likely to earn.

Stock Turnover Ratio

Cost of goods sold Average stock-1

(Average Stock Cost of goods sold-1) x 365

First formula gives you the number of times the stock turns over in a year while the second one gives you the number of days it takes for the stock to turnover

Return on Capital Employed  The profit and loss account shows the amount

that a business makes at the end of its trading year. However, this figure alone does not have much substance without making inter-firm or historical comparisons. For example, if a firm makes a $10 million profit, its performance is based on how well it had done in previous years, on how well rival firms are doing and the size of the business. Therefore, the ROCE measures the financial performance of a firm compared with the mount of capital invested. It is also an indicator of the profitability of a firm.

Return on Capital Employed NET PROFIT BEFORE INTEREST AND TAX       X100                  CAPITAL EMPLOYED  capital employed is the sum of the shareholders funds plus

reserves and and long term liabilities. The ROCE figure shows profit as a percentage of the capital used to generate it. The higher the ROCE figure, the better the business is running, although some sources refer to 20% being the target benchmark. As a general rule, the ROCE should at least exceed the interest rate offered at banks otherwise it would be more beneficial to simply deposit capital in an interest-bearing account. Many people regard ROCE as the single most important financial ratio as it measures how well a firm is able to generate profit from its sources of fund, hence it is often referred to as the key ratio.  

Debtor Days

Debtor days ratio/debt collection period: measurement of the number of days it takes a firm on average to collect money from its debtors (people who have purchased items on credit)

  Calculated with the formula: (Debtors/Sales revenue) X365 It is better for the company if the debtors pay on

time as it improves cash flow. Also the business could invest money into other revenue generating projects due to the opportunity cost of holding onto the money.

Debtor days

Problems when the ratio is too high/low Important that the credit period granted is not too long as it will

cause liquidity problems. Low ratio suggests customers seek other suppliers if the credit

period is uncompetitive (clients prefer better credit terms) Credit control: firm’s ability to collect debts within a suitable

timeframe (30-60 days) Improvements Imposing of surcharges to late payers. Giving debtors incentives (eg. discounts) to pay earlier/ before the

due date. - using of direct debit/autopay (financial services that uses funds directly from the client’s bank account on designated days) to settle bills. Eliminates the probability of paying late to avoid penalties when they forget to pay their bills.

Refuse further business with client until payment is made. (stopping supplies/suspending order)

Threaten legal action.