Efficiency Ratios (Cambridge (CIE) O Level Accounting)

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?

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  • This prevents the inventory from going out of date or out of season

Trade Receivables Turnover

What is the trade receivables turnover?

• 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

Trade Payables Turnover

What is the trade payables turnover?

• 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

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