Efficiency Ratios Notes

Revision notes on efficiency ratios for A2 Business Studies

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  • Created on: 25-03-08 16:29
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Lindsay Emma Rudd BMA
Efficiency Ratios
This group of ratios measures the effectiveness with which management controls the
internal operation of the business. They consider the following aspects of an enterprise
The extent to which assets are used to generate profits
How well stock is managed
The efficiency of creditor control ­ ie how long before customers settle their
accounts.
Three ratios fall under this heading.
Asset Turnover Ratio
This ratio measures a businesses sales in relation to the assets used to generate these
sales. The formula to calculate this is:
Asset turnover = Sales (turnover)
Assets employed
He formula measures the efficiency with which the businesses use their assets.
Using this Ratio
It is difficult to give a standard figure for this ratio as it varies significantly according to
the type of business.
A business with high sales and relatively few assets (a supermarket for example)
might have a high asset turnover ratio and earn low profits on each sale
Conversely other business may have a high value of assets, but achieve few sales so
have a low asset turnover ratio. The compensation for such a firm is that it normally
earns a high level of profit on each sale.
A business can improve its asset turnover ratio by improving its sale performance
and/or disposing of any extra unused assets.
Stock Turnover Ratio
This measures a company success it turning its stock into sales. The ratio compares the
value of stock with sales achieved valued at cost. This permits an effective comparison with
stock, which is always valued at cost. If a company makes a profit on each sale, then the
faster it sells its stock, the greater the profit it earns. The ratio is only of relevance to
manufacturing businesses, as firms providing services do not hold sufficient quantities of
stock.
Stock turnover = Cost of sales
Stock
The results of this calculation are expressed in the number of times a year.
Using this Ratio
The standard figure for this ratio varies hugely according to the type of business. For
example a market trader selling fruit and vegetables would expect to sell their entire
stock every two or three days, where as an antiques shop may only expect to sell
theirs every year or so.
A low figure of stock turnover could be due to obsolete stock. A high figure can indicate
an efficient business, although selling out of stock results in customer dissatisfaction.
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Lindsay Emma Rudd BMA
Improving the stock turnover ratio requires a business to hold lower levels of stock or to
achieve higher sales without increasing stock levels.
Debtors Collection Period / Debtor Days
This ratio calculates the time typically taken by a business to collect the money that it is
owed. This is an important ratio as granting customers lengthy periods of credit may result in
the business experiencing liquidity problems. If a company has substantial cash sales these
should be excluded from the calculation.…read more

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