Efficiency Ratios (Cambridge (CIE) IGCSE Accounting)

Revision Note

Written by: Dan Finlay

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?	$\frac{Cost of sales}{Average inventory}$
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- This prevents the inventory from going out of date or out of season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
- $\frac{Opening inventory + Closing inventory}{2}$
- $\frac{$ 7 000 + $ 9 000}{2} = $ 8 000$
Calculate the rate of inventory turnover
- $\frac{Cost of sales}{Average inventory}$
- $\frac{23 000}{8 000} = 2.875$
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?	$\frac{Trade receivables}{Credit sales} \times 365$
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
- $\frac{Trade receivables}{Credit sales} \times 365$
- $\frac{11 000}{40 000} \times 365 = 100.375$
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?	$\frac{Trade payables}{Credit purchases} \times 365$
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
- $\frac{Trade payables}{Credit purchases} \times 365$
- $\frac{4 000}{25 000} \times 365 = 58.4$
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.

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.

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.

Last updated: 24 May 2024

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Efficiency Ratios (Cambridge (CIE) IGCSE Accounting)

Revision Note

What are efficiency ratios?

Rate of Inventory Turnover

What is the rate of inventory turnover?

Worked Example

Trade Receivables Turnover

What is the trade receivables turnover?

Worked Example

Trade Payables Turnover

What is the trade payables turnover?

Worked Example

Evaluating Efficiency

How do I evaluate the efficiency of a business?

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

Worked Example

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Author: Dan Finlay

Author: Lucy Kirkham