📌 Definition Table

📌 Efficiency Ratios: How Well Does the Business Use Its Resources?

Efficiency Ratios examine an entity’s performance in terms of HOW it uses its resources (assets and liabilities). They measure how effectively the business manages inventory, collects from customers, pays suppliers, and uses borrowed capital. Unit 3.6 covers four efficiency ratios.

Data Source: Efficiency ratios come from the Balance Sheet and Profit & Loss Account. They measure the speed of resource turnover and capital efficiency.

📌 Stock Turnover Ratio

Stock Turnover Ratio shows how quickly the entity sells and replenishes its stock. It measures how many times per year the business sells through its entire inventory. The lower the ST ratio, the more efficient the entity is in generating profit from inventory.

📌 Formulas

Stock Turnover (times) = Cost of Sales ÷ Average Stock

Stock Turnover (days) = Average Stock ÷ Cost of Sales × 365

Where Average Stock = (Opening Stock + Closing Stock) ÷ 2

Example: Business has Cost of Sales £120,000, Opening Stock £10,000, Closing Stock £14,000. Average Stock = (£10,000 + £14,000) ÷ 2 = £12,000. ST (times) = £120,000 ÷ £12,000 = 10 times per year. ST (days) = £12,000 ÷ £120,000 × 365 = 36.5 days

📌 Interpretation and Strategies

Low ST ratio = More efficient. The business sells through stock quickly, tying up less capital in inventory. High ST ratio = Less efficient. Stock sits on shelves for a long time, tying up capital unproductively. Using the example: 10 times per year means the business sells and replenishes inventory 10 times annually, or every 36.5 days on average. A grocery store might have ST = 20 (sells through stock every 18 days). A luxury car dealer might have ST = 2 (sells through stock every 183 days).

What It Shows: Operational efficiency and inventory management. A high ST ratio (fast turnover) is good—capital isn’t trapped in inventory. A low ST ratio (slow turnover) can indicate problems: slow sales, overstocking, or obsolete inventory. However, context matters: luxury goods naturally have lower ST than groceries.

• Hold lower stock levels: Reduce average stock; stock still sells but is lower. Improves ratio.
• Sell goods with a discount: Lower prices increase sales volume and clear stock. BUT revenues/profits down.
• Introduce Just In Time (JIT): Hold 0 stock, order only as needed. Improves ratio dramatically. BUT hard to satisfy customers if demand spikes.

📌 Debtor Days (Receivables Ratio)

Debtor Days shows how long it takes to collect debt from customers. It measures the average number of days between when a sale is made (on credit) and when the customer pays the invoice.

📌 Formula

Debtor Days = (Debtors ÷ Sales Revenue) × 365

Example: Business has Debtors £25,000 and Sales Revenue £365,000. Debtor Days = (£25,000 ÷ £365,000) × 365 = 25 days

📌 Interpretation

The lower, the more efficient. Customers pay quickly; cash comes in fast. Business doesn’t need to borrow to finance working capital. The higher, the less efficient. Customers pay slowly; cash is tied up in unpaid invoices. Business must finance this gap with overdrafts or other short-term borrowing.

Benchmark: 30-60 days (depends on industry). If debtor days exceed this, it suggests customers are paying late or the business is offering overly generous credit terms. Using the example: 25 days is good—customers pay within about 25 days of purchase.

What It Shows: Cash collection efficiency and credit management. Low debtor days = good cash management, customers pay on time, no need for expensive short-term borrowing. High debtor days = either generous credit terms (to win sales) or collection problems. Either way, cash is tied up.

• Offer discounts for early payments: “Pay in 10 days, get 2% discount.” Encourages faster payment.
• Threaten late debtors with legal action: Aggressive debt collection improves debtor days BUT damages customer relationships.

📌 Creditor Days

Creditor Days shows how long it takes to pay creditors (suppliers). It measures the average number of days between when goods are purchased (on credit) and when payment is made to the supplier.

📌 Formula

Creditor Days = (Creditors ÷ Cost of Sales) × 365

Example: Business has Creditors £20,000 and Cost of Sales £120,000. Creditor Days = (£20,000 ÷ £120,000) × 365 = 61 days

📌 Interpretation

The higher, the better (within reason). The business takes longer to pay suppliers, improving cash flow. Money stays in the business longer before being paid out. BUT: Too high = bad relationships. If creditor days are extremely high, it suggests the business is delaying payments, damaging supplier relationships. Suppliers might refuse credit, demand cash on delivery, or switch to competitors.

Using the example: 61 days means the business takes about 2 months to pay suppliers. This is common (30-60 day payment terms are standard).

What It Shows: Working capital management and supplier relationships. Higher creditor days = better working capital (using supplier credit as free financing). BUT too high damages relationships. The ideal is to balance: take credit (improve cash flow) but pay on time (maintain good relationships).

• Develop trustworthy relationships with suppliers: Suppliers who trust the business are more willing to offer longer payment terms. Improves creditor days without damaging relationships.
• Look for other suppliers with favourable terms: Switch to suppliers offering longer payment periods. BUT might get lower quality or less reliable supply.

📌 Gearing Ratio (Financial Leverage)

Gearing Ratio shows the reliance on loan capital. It measures the proportion of the business financed by borrowed money (debt) versus owner investment (equity). It shows the financial leverage—how much the business borrows relative to what owners have invested.

📌 Formula

Gearing Ratio = (Loan Capital ÷ Capital Employed) × 100

Where:
– Loan Capital = Non-Current Liabilities (long-term debt)
– Capital Employed = Non-Current Liabilities + Equity

Example: Business has Long-term Loans £150,000, Share Capital £100,000, Retained Earnings £250,000. Capital Employed = £150,000 + £100,000 + £250,000 = £500,000. Gearing Ratio = (£150,000 ÷ £500,000) × 100 = 30%

📌 Interpretation

High Gearing (> 50%): The business is highly dependent on borrowed capital. Loans exceed equity. This means: High interest payments reduce profits. High financial risk—if business struggles, fixed loan repayments can cause failure. Banks are reluctant to lend more. Vulnerable to interest rate rises.

Low Gearing (< 50%): The business relies more on equity than debt. This means: Lower financial risk—fewer fixed obligations. Banks willing to lend more. Less vulnerable to interest rate rises. BUT: May be underutilising cheap borrowing.

Using the example: 30% gearing is low—the business is financed mostly by equity and relatively little debt. Low financial risk but could potentially borrow more cheaply.

What It Shows: Capital structure and financial risk. High gearing = more leverage but more risk. Low gearing = less risk but potentially missing opportunities to borrow cheaply and invest. The ideal gearing depends on the business and economy.

• Raise equity capital (sell more shares): Raise capital by selling shares rather than borrowing. Reduces gearing without reducing capital employed. Spreads ownership but reduces financial risk.
• Retain profits (don’t pay dividends): Retain all profits instead of distributing to shareholders. Increases retained earnings (equity), reducing gearing. BUT disappoints shareholders expecting dividends.

📌 Insolvency vs. Bankruptcy: Two Different Problems

Insolvency and bankruptcy are related but different. Both indicate financial distress, but they describe different situations with different implications.

📌 Insolvency

Insolvency: Current Liabilities > Current Assets

Situation: The business can’t pay on time. Short-term debts exceed short-term assets. It can’t meet immediate obligations (paying wages, paying suppliers, paying interest).

Process: Flexible. The business can try to improve (increase sales, reduce expenses, borrow more). It’s a liquidity crisis—the business may recover.

Example: A business has Current Liabilities of £50,000 but Current Assets of only £30,000. It’s insolvent. It can’t pay bills as they come due. It needs cash injection, short-term borrowing, or asset sales to become solvent again.

📌 Bankruptcy

Bankruptcy: The business can’t pay at all (in a legal sense).

Situation: The business is unable to meet any of its financial obligations. It’s declared bankrupt by a court. All assets are seized and sold to pay creditors (to the extent possible).

Process: Inflexible. Bankruptcy is a legal process. The business typically ceases operations. Assets are liquidated. Creditors recover what they can (often only a fraction of what they’re owed).

Example: A business has total debts of £100,000 but total assets worth only £30,000. Even if all assets are sold, creditors only recover £0.30 per £1 owed. The business is bankrupt and ceases operations.

📌 Key Takeaways and Application to Exam Questions

Unit 3.6 on Efficiency Ratios and Gearing provides tools for assessing operational efficiency and financial structure. Key concepts to master:

Efficiency = Speed of Resource Use: All three working capital ratios (stock, debtor, creditor days) measure how quickly resources flow through the business. High stock turnover, low debtor days, and appropriately balanced creditor days together indicate efficient working capital management.

Context Matters: A grocery store’s stock turnover cannot be compared to a luxury car dealer’s; different industries have different norms. When evaluating ratios, compare to industry benchmarks and competitors, not to absolute standards.

Gearing as Strategic Choice: High gearing isn’t always bad—during economic growth, leverage can amplify returns. Low gearing isn’t always good—it might indicate underutilised borrowing capacity. The right gearing depends on business risk tolerance and economic conditions.

Insolvency vs Bankruptcy Clarity: These are different problems requiring different solutions. Insolvency is a liquidity issue (fixable through working capital management, short-term borrowing, asset sales). Bankruptcy is a structural issue (often unfixable; business typically ceases).

Integrated Analysis: Use all efficiency ratios together. A business might improve stock turnover but damage debtor collection. Another might stretch creditor days to dangerous levels. Sophisticated analysis examines these interconnections and evaluates trade-offs between short-term efficiency and long-term business viability.