Financial Efficiency Ratios (Cambridge (CIE) A Level Business): Revision Note

The meaning and importance of financial efficiency

• Financial efficiency is a measure of how well a business utilises its assets and liabilities to generate sales and maximise profits 

• Efficiency ratios provide insights, 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

Why financial efficiency is important

• Improves profitability

  • Efficient use of resources, like controlling costs or managing inventory, helps increase profit margins

• Supports cash flow management

  • Financial efficiency ensures a business can pay its bills on time and avoid cash shortages

• Boosts competitiveness

  • A financially efficient business can keep prices lower or invest more in quality and innovation, giving it a competitive edge over rivals

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

• 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

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

Trade receivables turnover

• The trade receivables turnover ratio 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

Trade payables turnover

• The trade payables turnover ratio measures the average number of days a business takes to pay invoices owed to creditors

• It is calculated using the formula

Methods of improving financial efficiency

1. Improving the inventory turnover ratio

• In general terms, the higher the inventory turnover ratio, the better

• 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

Ways to improve the inventory turnover ratio

2. Improving the trade receivables turnover ratio

• 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 trade receivables turnover 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 trade receivables turnover ratio

3. Improving the trade payables turnover ratio

• 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

Ways to improve the trade payables turnover ratio

• Taking longer than agreed to pay outstanding invoices can 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