Efficiency Ratios

Three most common ratios:

  • Inventory turnover- how often each year a business sells and replaces its inventory
  • Payables days- the length of time taken by a business to pay amounts it owes
  • Recievables days- the length of time taken by customers to pay amounts owed. 

Inventory turnover = cost of sales/ inventories 

Some sectors like engineering, construction and industrial distribution will have low inventory turnover. 

It is important to remember that:

  • It varies from industry to industry
  • Holding inventory may improve customer service
  • Seasonal fluctations in demand 
  • Inventory turnover is not relevant to most service businesses

How can a business immprove its invenotry turnover?

  • Sell or dispose of slow-moving or obselete industry
  • Introduce lean production
  • Rationalise thhe prouct range
  • Negotiae sale or return arrangements. 

Payable days= trade payables/cost of sales x365

Recievable days= trade recievables/revenue x365

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Gearing measures the proportion of a business' capital privuded by debt. 

Equity finance is invested by the owners of the business.- Higher equity is helpful when there is higher risk and more flexibility is requred.

Debt finance is provided to the business by external parties. Higher debt is helpful when interest rates are low and where profits and cash flows are strong.

Key benefits of calculating gearing:

  • It is a useful measure of the financial health of a business
  • Focuses on the level of debt
  • A high gearing ratio can mean higher risk of business failure.

Gearing =  non-current liabilities/ (total equity and non-current liabilities) x100

Benefits of high gearing:

  • Less capital required to be invested
  • Debt can be a relatively cheap source of finance.
  • Easy to pay interest.

Benefits of low gearing:

  • Less risk of defaulting on debts
  • Shareholders rather than debt providers
  • Business has the campacity to add debt if required. 
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Role, Value and Limitations of Financial Ratios

Ratio analysis involves the comparison of financial data to gain insights into business performance. 

Effective ratio analysis means you:

  • Need to compare with competitors 
  • Need to analyse over time

Income statement- revenues, cost of sales, gross profit, operating profit, net profit.

Statement of financial position- current assets, current liabilites, inventories, trade recievables, long term liabilites and capital reserves. 

Profitability ratios- shareholders, government, competitors, employees

Liquidity- shareholders, lenders, suppliers

Financial efficiency- shareholders, lenders and competitors 

Key limitations include:

  • One data set is not enough
  • How reliable is the financial data? 
  • Ratios are based on the past
  • Comparability
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Profitability (Return on Capital Employed)

ROCE tells us what returns the business has made on the resource avaliable to it. ROCE is particularly useful as a ratio as it helps:

  • Evalyuate the overall performance of a business 
  • Provide a target return for individual projects
  • Benchmark performance with competitors

ROCE = operating profit/(total equity+non-current liabilites) x 100

Key points to remember are:

  • ROCE will vary between industries
  • ROCE is based on a snapshot of a business' balance sheet
  • Comparisons over time and with key competitors are most useful
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Liquidity (Current Ratio)

Liquidity is concerned with the ability of a business to be able to pay its way. 

A liquidity ratio asssesses whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due. 

Current assets/current liabilites 

Evaluating the Current Ratio:

  • A ratio of 1.5- 2.5  suggest acceptable liquidity 
  • Low ratio indicates possible liquidity problems
  • High ratio: suggests too much working capital tied up in the inventories or debtors?

However don't forget, 

  • The industry or market matters
  • How does the current ratio compare with competitors?
  • The trend is more important 
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