Efficiency Ratios: Stock Turnover & Gearing Ratio (DP IB Business Management)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
An Introduction to Efficiency Ratios
Efficiency ratios show how well a business utilises its assets and liabilities to generate sales and maximise profits
They can provide insights into the operational efficiency of a business, including
How well stocks are being managed
The time taken for a business to settle debts with its creditors
How well credit offered to customers is being controlled
The balance of business funding between loans and equity capital
Stakeholders, such as investors, can use the ratios to assess how well a company manages its resources
Management can use ratios to set targets for key staff
Diagram: The four main Efficiency Ratios
Efficiency ratios provide insights into the operational efficiency of a business
Stock Turnover
The stock turnover ratio shows how well a business converts its stock into sales
Before calculating stock turnover it is first necessary to calculate the average value of stock held by a business in a given period
It is calculated using the formula
Calculating the Stock Turnover Ratio
Stock turnover can then be calculated in two ways
1. Number of times a business sells all of its stock during a period (usually a year)
Businesses aim for a high or increasing ratio
More stock sold means that it is generating profit more efficiently
Perishable goods are less likely to be wasted
2. Number of days taken to sell all of its stock
Businesses aim for a low or falling ratio
Selling stock quickly means profit is achieved swiftly
Less likely to hold obsolete stock that may need to be sold at a loss
Worked Example
YakPur Fashions is a manufacturer and exporter of high quality fashion outerwear
A selection of YakPur Fashions' financial performance indicators are shown in the table
Selected Financial Performance Data 2022 YakPur Fashions | |
---|---|
| € |
Stock held on 1st January 2022 | 47,600 |
Credit Sales Revenue | 241,200 |
Cost of Sales | 112,400 |
Stock held on 31st December 2022 | 26,000 |
Debtors on 31st December 2022 | 31,200 |
Creditors on 31st December 2022 | 28,500 |
(a) Calculate YakPur Fashions' stock turnover ratio for 2022
(i) in terms of the number of times stock was sold during the year
(ii) in terms of the number of days taken to sell all stock
(4 marks)
Step 1: Calculate the average value of stock
(1)
Step 2: Calculate the number of times stock sold during the year
(1)
Step 3: Calculate the number of days taken to sell stock
(2)
Ways to improve the stock turnover ratio
The stock turnover ratio can be improved by holding less stock or reducing cost of sales
Improving the Stock Turnover Ratio
Hold less stock | Reduce the cost of sales |
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Stock turnover variations
There is no ideal ratio for stock turnover
Some businesses will have a very low stock turnover ratio as they sell few products - usually at a high price
Examples include
Jewellers
Luxury vehicles
Specialist equipment or services
Other businesses have a very high stock turnover ratio
Their business model often requires this - for example, they may sell perishable goods
Example include:
Supermarkets
Florists
Takeaway food businesses
Gearing Ratio
The gearing ratio illustrates the long-term financial structure of the business
It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used to fund a business
The outcome is expressed as a percentage and is calculated with the following formula
Capital employed can be calculated by adding non-current (long term) liabilities to the equity
Interpreting the results
If the outcome is less than 50% the business is low-geared
The business is largely funded by shareholder capital
If the outcome is more than 50% the business is highly-geared
The business is largely funded by loan capital
Worked Example
The table shows an extract from the company accounts of Keals Cosmetics.
| $ |
---|---|
Current Assets | 6.2 million |
Current Liabilities | 3.4 million |
Non-current Liabilities | 9.6 million |
Capital Employed | 43.3 million |
Calculate Keals Cosmetics' gearing ratio
(2 marks)
Step 1: Identify the data required to calculate the gearing ratio
Non-current liabilities = $9.6 million
Capital employed = $43.3 million
Step 2: Divide non-current liabilities by capital employed
$43.3 million ÷ $9.6 million = 0.22 (1)
Step 3: Multiple the outcome by 100 and express the result as a percentage
0.22 x 100 = 22% (1)
22% of Keals Cosmetics capital structure is made up of long-term loans
It is a low-geared business
Problems associated with high gearing
The higher the gearing ratio the more dependent a business is on long-term borrowing
High gearing can be problematic for several reasons
Risks Associated with High Gearing
Financial Risk | Cash Flow & Investment Constraints |
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Investor Perception | Credit Rating Impact |
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Situations where high gearing is less problematic
When interest rates are low - and expected to remain low
Interest rates in Europe have been historically low for more than a decade
Many businesses have taken advantage of borrowing cheaply to fund investment
Large and profitable businesses are capable of meeting debt obligations
Multinational car manufacturers such as Toyota and Volkswagen are highly geared
High levels of borrowing have funded research into new generations of electric vehicles
Ways to improve gearing
Improving gearing usually means lowering it
This can be achieved by reducing long-term borrowing or raising more equity capital
Ways to Improve Gearing
Reduce Long-term Borrowing | Raise Equity Capital |
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Examiner Tip
High gearing should always be balanced with the need to grow
Without external finance many businesses would struggle to make crucial capital investments that could increase output, improve productivity or increase efficiency
Businesses need to carefully weigh up how much debt it can manage before it outweighs the benefits of growth
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