Efficiency Ratios: Stock Turnover & Gearing Ratio (DP IB Business Management)

Revision Note

Flashcards
Lisa Eades

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

ibdp-business-management-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

Average space stock space equals space fraction numerator Opening space stock space plus space Closing space stock over denominator 2 end fraction
  

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
     
    fraction numerator Average space Value space of space Stock over denominator Cost space of space Sales end fraction space cross times space 365

  • 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

fraction numerator Opening space stock space plus space Closing space stock over denominator 2 end fraction

equals space fraction numerator € 47 comma 600 space plus space € 26 comma 000 over denominator 2 end fraction

equals space € 36 comma 800    (1)

Step 2: Calculate the number of times stock sold during the year

fraction numerator Cost space of space sales over denominator Average space stock end fraction

equals space fraction numerator € 112 comma 400 over denominator € 36 comma 800 end fraction

equals space 3.05 space times     (1)

 

Step 3: Calculate the number of days taken to sell stock

fraction numerator Average space stock over denominator Cost space of space sales end fraction space cross times space 365

equals space fraction numerator € 36 comma 800 over denominator € 112 comma 400 end fraction space cross times space 365

equals space 119.50 space days     (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

  • Reorder from suppliers more regularly

  • Implement a just-in-time stock management approach

  • Dispose of obsolete stock

  • Reduce the product range

  • Seek lower-cost suppliers

  • Purchase in bulk to achieve purchasing economies of scale 

  • Reduce storage costs such as security

 

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

Gearing space Ratio space equals fraction numerator space Non space Current space Liabilities over denominator Capital space Employed end fraction space straight x space 100

  • 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

  • Rising interest rates are problematic

    • If interest rates rise the cost of repaying loans rises

    • May put strain on the businesses finances

  • High gearing reduces profitability

    • Large portion of revenue goes towards repaying debt

    • May be better to reinvest /pay shareholder dividends

  • High gearing strains cash flow

    • During an economic downturn the business may struggle to generate enough cash to pay debts 

  • High gearing limits funds for investments

    • Research and development, new projects or other growth opportunities may be unaffordable

Investor Perception

Credit Rating Impact

  • High gearing is associated with financial risk

    • Could make it difficult to attract investors

    • May lead to a lower share price 

  • High gearing can impact credit rating

    • May mean higher interest rates on future borrowings

    • Difficult to access additional funds

 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

  • Repay existing debt to reduce the overall debt burden

  • Pay off high-interest debt first to minimise interest costs

  • Negotiate with creditors to restructure existing debt

  • Raise share capital by issuing new shares or consider a rights issue

  • Retain profits instead of distributing profits as dividends

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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Lisa Eades

Author: Lisa Eades

Expertise: Business Content Creator

Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.