Efficiency Ratios (AQA A Level Business): Revision Note

Introducing efficiency ratios

• Efficiency ratios are valuable because they highlight how well a business manages its resources and operations, helping to identify areas where performance and cash flow can be improved

Payables days

• Payables days measures the average number of days a business takes to pay invoices owed to creditors

• It is calculated using the formula

• Businesses generally aim for a high or increasing ratio

  • This indicates skills of negotiation in arranging extended credit terms with suppliers

  • Delaying payments to suppliers can improve cash flow

• However, taking longer than agreed to pay outstanding invoices may have negative consequences

  • Relationships with important suppliers may worsen

    • They are less likely to extend further trade credit 

    • Penalties may be issued for late payment 

    • Orders may be delayed until payment is received

  • Creditworthiness may worsen

    • A business may fail credit checks

    • Unable to place orders with other suppliers

    • Less chance of obtaining trade credit elsewhere

    • Could impact applications for borrowing e.g. loans

Improving the payables days ratio

Receivables days

• Receivables days measures the average number of days it takes for a business to collect money from its debtors

• Businesses often provide a period of trade credit to customers

  • In the UK 30 to 60 days is typical

  • The growth of promotional 'buy now, pay later' deals has increased the level of debtors for some businesses

• It is calculated using the formula

• Businesses aim for a low or reducing ratio

  • This indicates efficiency in collecting outstanding debts from credit customers

  • Collecting debts promptly can improve cash flow

Ways to reduce the receivables days ratio

• If these methods fail to persuade customers to pay their invoices on time a business has a range of further options. These methods should be pursued with caution as relationships with customers may be damaged

Further ways to reduce the receivables days ratio

Comparing payables days and receivables days

• Comparing receivables days and payables days helps assess how well a business manages its cash flow and short-term liquidity

  • If receivables days are greater than payables days, the business waits longer to collect cash than it does to pay suppliers

    • This creates a cash outflow gap that must be financed from cash reserves or borrowing, reducing liquidity

  • Conversely, if payables days are greater than receivables days, suppliers effectively finance the business

    • This eases the pressure on liquidity, so the business can meet its short-term obligations without running out of cash

Inventory turnover

• The inventory turnover ratio shows how well a business converts its stock into sales

• Before calculating inventory 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 inventory turnover ratio

• Inventory turnover can then be calculated in two ways

1. The 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. The 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

Improving the inventory turnover ratio

Inventory 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 and specialist equipment or services

  • Other businesses have a very high stock turnover ratio as they sell large volumes of low or moderately-priced products

    • Their business model often requires this - for example, they may sell perishable goods

    • Examples include supermarkets, florists or takeaway food businesses

Evaluation of ratio and efficiency analysis

• A range of factors can affect how useful ratio analysis is in supporting business decision-making

  • The business’s market position

    • A market leader’s ratios (e.g. high profit margins) may look very different to those of a small rival, so comparing them directly can be misleading without adjustments for size

  • Quality of management decision making

    • Strong management can boost key ratios by making choices like cutting costs that may hide longer-term problems

    • Poor decisions can worsen ratios even if the wider market is performing well

  • Workers’ and management skills

    • A highly skilled workforce and experienced managers improve productivity and efficiency ratios, such as inventory turnover

  • The economic environment

    • In a recession, profitability and liquidity ratios tend to fall for most businesses, so low ratios may reflect the wider economy rather than internal failings

  • Market conditions

    • Industry-specific factors such as seasonal demand swings, intense price competition or new regulations, can skew ratios, making it hard to tell if a ratio change is a company problem or an industry trend

Advantages and disadvantages of using ratio analysis to assess business performance