Efficiency Ratios (Cambridge (CIE) IGCSE Accounting)

Revision Note

Dan Finlay

Written by: Dan Finlay

Reviewed by: Lucy Kirkham

What are efficiency ratios?

  • Efficiency ratios are ways to measure how efficient a business is at managing processes linked to buying and selling goods

  • They compare trade receivables, trade payables and inventory with credit sales and purchases and the cost of sales

    • They indicate how efficient a business is at

      • Receiving payments from customers

      • Making payments to suppliers

      • Selling its inventory

  • The efficiency ratios are:

    • Rate of inventory turnover

    • Trade receivables turnover

    • Trade payables turnover

Rate of Inventory Turnover

What is the rate of inventory turnover?

What is the formula?

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

How should the value be written?

Write as the number of times per year (X times)

How should the value be rounded?

Round to two decimal places

What does the value mean?

The value represents the number of times a business is able to fully sell and replace its inventory in a year

How can the ratio be improved?

  • Increase the volume of sales

  • Reduce the amount of inventory that is held by the business

  • It can be easier to think of the rate in terms of how long it takes for a business to fully sell its inventory without replacing it

    • If the rate of inventory is 2 then this means it takes the business half a year to fully sell its inventory without replacing it

    • You can divide 365 days by the rate to find the number of days it takes to fully sell the inventory without replacing it

  • A business aims to sell its inventory quickly

    • This prevents the inventory from going out of date or out of season

Worked Example

Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.

$

Sales

40 000

Purchases

25 000

Inventory at 1 March 2023

7 000

Inventory at 29 February 2024

9 000

Calculate the rate of inventory turnover for the year ended 29 February 2024. The calculation should be correct to two decimal places.

Answer

  • Calculate the cost of sales

    • Opening inventory + Purchases - Closing inventory

    • $7 000 + $25 000 - $9 000 = $23 000

  • Calculate the average inventory

    • fraction numerator Opening space inventory space plus space Closing space inventory over denominator 2 end fraction

    • fraction numerator $ 7 space 000 space plus space $ 9 space 000 over denominator 2 end fraction equals $ 8 space 000

  • Calculate the rate of inventory turnover

    • fraction numerator Cost space of space sales over denominator Average space inventory end fraction

    • fraction numerator 23 space 000 over denominator 8 space 000 end fraction equals 2.875

  • Round to two decimal places

    • Rate of inventory turnover = 2.88 times

Trade Receivables Turnover

What is the trade receivables turnover?

What is the formula?

fraction numerator Trade space receivables over denominator Credit space sales end fraction cross times 365

How should the value be written?

Write as the number of days (X days)

How should the value be rounded?

Round up to the next whole day

What does the value mean?

The value represents the average number of days it takes a business to receive full payment for goods sold to credit customers

How can the ratio be improved?

  • Encourage credit customers to pay quickly

    • Offer cash discounts

    • Charge interest for late payments

  • Reduce the amount owed by customers

    • Enforce a credit limit

    • Require a cash deposit

  • A business will aim to receive payment from customers as quickly as possible

  • A business might offer credit to customers:

    • To get ahead of the competitors

    • To potentially receive larger orders from customers

Worked Example

Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.

$

Sales

40 000

Trade receivables

11 000

All sales were made on a credit basis.

Calculate the trade receivables turnover for the year ended 29 February 2024. round up your answer to the next whole day.

Answer

  • Calculate the trade receivables turnover

    • fraction numerator Trade space receivables over denominator Credit space sales end fraction cross times 365

    • fraction numerator 11 space 000 over denominator 40 space 000 end fraction cross times 365 equals 100.375

  • Round up to the next whole day

    • Trade receivables turnover = 101 days

Trade Payables Turnover

What is the trade payables turnover?

What is the formula?

fraction numerator Trade space payables over denominator Credit space purchases end fraction cross times 365

How should the value be written?

Write as the number of days (X days)

How should the value be rounded?

Round up to the next whole day

What does the value mean?

The value represents the average number of days it takes a business to fully pay for goods purchased from credit suppliers

How can the ratio be increased?

  • Take advantage of any interest-free periods

    • This helps the business keep their cash for as long as possible in case of emergencies

How can the ratio be decreased?

  • Pay for goods using cash when possible

  • Pay invoices quicker

  • There are benefits to paying for goods using credit:

    • The business can keep its cash for as long as possible in case of emergencies

    • The business can wait until it receives payment from customers before paying its suppliers

  • There is no optimal value for the trade payables turnover

    • The value should not be too high otherwise the business might be charged interest or late fees

    • The value should not be too low otherwise the business will have a low working capital

Worked Example

Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.

$

Purchases

25 000

Trade payables

4 000

All purchases were made on a credit basis.

Calculate the trade payables turnover for the year ended 29 February 2024. round up your answer to the next whole day.

Answer

  • Calculate the trade payables turnover

    • fraction numerator Trade space payables over denominator Credit space purchases end fraction cross times 365

    • fraction numerator 4 space 000 over denominator 25 space 000 end fraction cross times 365 equals 58.4

  • Round up to the next whole day

    • Trade payables turnover = 59 days

Evaluating Efficiency

How do I evaluate the efficiency of a business?

  • Look at all the efficiency ratios together

  • The rate of inventory turnover tells you how quickly the business can sell its inventory

    • The higher the rate, the better the liquidity of the business

  • Look at the difference between the trade receivables turnover and trade payables turnover figures

    • It is better if the trade receivables turnover is lower

      • This means the business receives money from its credit customers before paying its credit suppliers

      • This helps with the liquidity of the business

      • The difference between them is then the number of days that the business has the money from the customers before paying the suppliers

    • If the trade receivables turnover is higher:

      • The business pays its suppliers before receiving money from its customers

      • This could result in the business taking out short-term loans to pay its suppliers

How do I compare the efficiency of a business over the years?

  • Compare the ratios to the same ratios from previous years

  • For each ratio

    • Make a general comment

      • State whether it has improved or gotten worse

      • State the ratios

    • Give possible reasons for the change

  • Look at the difference between the trade receivables turnover and the trade payables turnover

    • Comment on the difference

Worked Example

Odin is a sole trader and his financial year ends 31 October. He provides the following information.

Year ended

31 October 2022

31 October 2023

Rate of inventory turnover

8.25 times

10.40 times

Trade receivables turnover

35 days

27 days

Trade payables turnover

20 days

28 days

(a) Explain why Odin is satisfied with the change in the rate of inventory turnover.

(b) Suggest two reasons for the decrease in Odin's trade receivables turnover.

(c) Suggest two reasons for the increase in Odin's trade payables turnover.

Answer

(a) State the benefits of having a higher rate of inventory turnover.

The rate of inventory turnover has improved by increasing from 8.25 times to 10.40 times. This means Odin sold his inventory at a faster rate than the previous year. This has improved the liquidity of the business as Odin is able to convert assets into cash more quickly.

(b) Give two reasons why the trade receivables turnover might decrease.

On average, Odin is receiving payment from his credit customers 8 days faster.

One possible reason is that Odin has started to offer cash discounts for early repayment.

Another possible reason is that Odin has increased the amount of interest that is charged on overdue balances.

(c) Give two reasons why the trade payables turnover might increase.

On average, Odin is paying his credit suppliers 8 days slower.

One possible reason is that Odin has less available cash to pay his suppliers as promptly.

Another possible reason is that the suppliers are no longer offering cash discounts for early repayments. In this case, Odin is taking longer to pay but still aiming to avoid overdue fees.

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Dan Finlay

Author: Dan Finlay

Expertise: Maths Lead

Dan graduated from the University of Oxford with a First class degree in mathematics. As well as teaching maths for over 8 years, Dan has marked a range of exams for Edexcel, tutored students and taught A Level Accounting. Dan has a keen interest in statistics and probability and their real-life applications.

Lucy Kirkham

Author: Lucy Kirkham

Expertise: Head of STEM

Lucy has been a passionate Maths teacher for over 12 years, teaching maths across the UK and abroad helping to engage, interest and develop confidence in the subject at all levels.Working as a Head of Department and then Director of Maths, Lucy has advised schools and academy trusts in both Scotland and the East Midlands, where her role was to support and coach teachers to improve Maths teaching for all.