3.6 Efficiency ratio analysis ‘Aggood cecision is based on knowledge and not on numbers. Plato (427-347 BCE), Greek philosopher [HL content ‘The following further efficiency ratios + inventory/stock turnover + debtor days + creditor days + gexring ratio. Efficiency ratios lowing. forth wentory/stack jes so linprove ex AOS been used, such asthe amount of time taken by the firm to sell its stock (inventory) or the average number of days taken to collect money from its debtors, Supermarkets, for ‘example, sell their stocks faster than luxury jewellers. There are four main aditional efficiency ratios for FL. students to learn stock turnover, debtor days, creditor days and the gearing ratio. Stock turnover E== ratios show how well firms resources have ‘The stock tumover ratio (or inventory turnover ratio) ‘measures the number of times a firm sells its stocks within a time period, usually one yea. The ratio therefore indicates the ‘speed at whic a firm sells and replenishes all its sick, There are two alternative ways to caleulate stock tuenover: Stock turnover (number of times) = -Costof goods sold_ Average stock or Stock turnover (number of days) = Average stock 365, Cost of goods sold When looking a stock turnover, cost of goods sold is used (Gather dhan sles tumover) a8 stocks are valued at cost value of the inventory (tothe busines) rather than selling price Assessment objective ‘A02, AO4 For example, fa business has COGS equal to $100 000 and an average stock level valued at $20 000 then the stock tumover ratio is 5 times a year (or every 73 days on average). This ‘means that the business sels all ofits inventory, which is then replenished, five times a year. Using this calculation, the higher the ratio the better it is for the firm because more stock is sole and therefore the more efficient it isin generating profit. A high stack turnover also means that perishable stock does not expire or stock does not become outdated. “There ae several ways that a firm's stock level can be reduced to improve its stock turnover ratio: + Holding lower stock levels requires inventories to be replenished more regularly (which can have both advantages and disadvantages ~ see Unit 5.5). + Divestment (disposal) of stocks which are slow to sell. ie. getting rid of obsolete stock and unpopular products in the firms portfolio. + Reduce the range of products being stocked by only Keeping the best-selling products When comparing this ratio, it is important (as always) to ‘compare like-with-like, Different businesses have different ‘benchmark figures for stock turnover. For example, a restaurant should expect a significantly higher stock turnover ratio than a seller of luxury motor vehicles. A stock turnover rate of $ is perhaps acceptable to suppliers of consumer durables, but ‘unacceptable to a florist or fresh fish monger. Hence, a low stock turnover ratio is not necessarily bad signal ratios must be put into contest. 283of Section 3 Finance and accounts Debtor days ‘The debtor days ratio measures the number of days it takes a firm, on average, to collect money from its debtors. Hence, it is sometime referred to as the debt collection period. Debtors are the customers who have purchased items on trade credit and therefore ove money to the fim. Its calculated using the formula: Debtor days = —Debtors __ 365 Sales revenue For example, if firmis debt (shown on its balance sheet) totals $1 million whilstits sales turnover is $5 million, then the ratio is 73days, ic it takes the business an average of 73 days to collect debts from its customers who have bought items on credit Logically, ta ess time it takes for customers to pay their debts, the better it is forthe business. There are two reasons for this: first, the business improves its cash flow if customers pay on time and second, due to the opportunity cost of holding onto ‘money, the business could invest this money in other reventie- generatingprojecs. However, a ratio that is too high or too low can also be problematic: + Although firms may allow customers to buy on credit, it is important thatthe credit period granted is not too long, otherwise the businesses could face liquidity problems (oe Unit 37). + Equally, too low a ratio suggests customers may seek other suppliers if the credit period given to them is ‘uncompetitive because clients prefer better credit terms. It is quite common to allow customers 30-60 days trade credit, ‘The fiemis ability to collect debts within a suitable timeframe is known as credit control. A business is generally seen as having, ‘good credit control if it can collect debts within 30-60 days. Businesses can improve their debt collection period in several ways + Impose surcharges on late payers. For example, banks and utility companies add a fine to those who pay their bills late. In some countries, such as Hong Kong, the government will impose a surcharge on income tax bills for late payers. + Give debtors incentives to pay earlier, such as giving a discount to those who pay their bills before the due date. ‘Many firms encourage their credit customers to use direct debit or autopay. These are financial services that involve transferring money owed to creditors by using funds 284 directly from the clients bank account on designated ays. ‘Tis saves customers having to remember when to pay their bills and hence avoid penalties for paying lt + Refuse any further business with a client until payment is made, This may include stopping supplies to a customer or suspending an order until payment is received. + Threaten legel action. The threat of taking a customer fo court is rather extreme but is often used for clients who repeatedly pay late Some businesses, such as suppliers of expensive luxury. ‘goods, rely more on credit sales than others. Hence, for these businesses itis more acceptable to have a higher debt collection period. Fast food restaurants or hair salons, on the other Fand, Ihave customers paying for their goods atthe time of purchase 40 their debt collection period would be mach lower, Creditor days “The creditor days ratio measures the number of days it takes, ‘on average, for a business to pay its trade creditors. The formula Jor this ratio iss, Creditor days = ——Credlitars x 365 Cost of goods sold For example, if a business has $225 000 owed to its suppliers (as sen from its balance sheet) with $2 million worth of cost of goods sold (COGS), then the ezeditor days ratio is 41 days. This means the business takes 4 days on average to pay its suppliers. Tis common to provide customers with 30-60 days credit, so@ creditor days ratio in this range would seem acceptable. ‘Akigh creditor days ratio means that repayments are prolonged, ‘This can help to free up cash in the business for other use (in the short term). However: a high ratio might also mean thet the business is taking too long to pay its creditors so suppliers may {impose financial penalties for late payment. In this case, ahigh creditor days ratio will harm the firms cash flow position ‘The efficiency position of a firm can be enhanced by improving any of its efficiency ratios, ie, increasing stock turnover, reducing debtor days, and increasing creditor days. Strategies t0 achieve this include: + Developing closer relationships with customers, suppliers and creditors, thereby helping to reduce the debt collestion| time and extend the credit period.Introduce a system of just-in-time production (see Unit 5,5) to eliminate the need to hold large amounts of stock ‘and to improve stock control. Gearing ratio ‘The gearing ratio is used to assess a firms long-term liquidity position. Ths is done by examining the firms capital employed that is financed by long-term debt, such as mortgages and debentures (see Unit 3.1). Gearing enables managers to gauge the level of efficiency in the use of a firms capital structure, The gearing rato formula is: Gearing ratio = -Lens-term liabilities. 499 Capital employed or Gearing ratio= —Loan capital __ 199 Capital employed For example, « business with long-term licbilties totalling §5 million whilst its capital employed is $15 million has a fearing ratio of 333%. This means that one-third ofthe firms sources of finance comes fivin eatetnel interest-bearing sources, whilst the other two-thirds represent internal sources of finance. Recall from Unit 3.5 that Capital employed = loan csptal (or long, term liabilities) + share cpital + retained profit, ‘The higher the gearing ratio, the larger the firm's dependence ‘on long-term sources of borrowing, This means that the firm incurs higher costs due to debt financing, such as interest repayments to banks or debenture holders. This can therefore limit the net profit for the fem, Creditors and investors are interested in the level of gearing of firm, A firm is said to be highly geared iit has a gearing ratio ‘oF 50% or above. Such firms are more vulnerable to increases in Interest rates, This situation is similar to an individual who has uestion 3.6.1 Calculating efficiency ratios Calculate the following ratios for JKL Ltd. for both years: stock tumover, debtor days and creditor days. Examine the ways in which JKL Ltd. could improve its efficiency postion. Using your answers from part (a) above, evaluate the efficiency position of JKL Ltd. ERM aus eee BUEN Ae + Improve credit control, Le: managing risks regaring the amount of credit given to debtors. For example, giving customers an incentive to pay earlier or on time helps to reduce the chances of tad debts (loans that do not get repaid) [6 marks} 6 morks} fRmarks} a large mortgage with a bank. A rise in interest rates will mean such individuals will have higher monthly interest repayments, ‘on their outstanding mortgages. Similarly, a highly geared business will be more exposed to interest rate increases or if there isa downturn in the economy as loan repayments remain, high, while cash inflow from sales will tend to fallin a recession. Other financiers are less likely to lend money to firms that are already highly geared due to their Jarge loan commitments. Such fiems are more prone to experience financial dificulties ‘and may be taken over by larger rivals. Shareholders and potential investors are also interested in. the gearing ratio as it helps to assess the level of risk. Since financiers have to be repaid first (with interest), this may reduce the amount paid to shareholders and the amount retained for reinvestments, However if the profitability of the firm is high, then potential returns can be very attractive even in highly geared firms. Although gearing can make profits more volatile, businesses tend to require external finance to fund their expansion. The phrase ‘you need money to make money’ suggests that external financing can help businesses to grow. American property tycoon Donald Trump made his wealth largely through high gearing as internal sources of finance are rarely sufficient to fund the rapid growth of a business. The problem facing. finance managers is how much debt the firm can handle before the benefits of growth outweigh the costs of high gearing and. financial risks.Bese Section 3 Finance and accounts ‘The level of gearing that is acceptable to a business will depend, of several factors such as «+The size and status ofthe business ~ Generally, there is a positive correlation between a firmissize and status and its ability to repay long-term debts. Most stakeholders would not worry too much if McDonalds had a gearing ratio of, 500% as it likely to be able to repay the debs. +The level of interest rates ~ IF interest rates are low, then ‘businesses are less vulnerable (atleast in the short term) ‘even with high gearing. For example, durlag Japan's recession in the 1990s, interest rates were close to zer0 pper cent, This would minimise the interest repayments on long-term external finance, + Potential profitability ~ If firms have good profit gulity (ong-term prospects of making profit) then high gearing is less likely to be an issue. This applies to many firms in high-tech industries that invest heavily in research and development. They may need external finance to fund the expenditure on R&D bat the potential for high returns an minimise their exposure to gearing, Theory of knowledge Numbers canbe manipulated in such a wey that they earl ale reer extent do you agree with this statement? Question 3.6.2 Calculating gearing ratios a) JKL Ltd, nas issued debentures valued at $250 000. Outline what is meant by debentures. {b) Calculate the gearing ratio for JKL Ltd. for both years. (6) Explain what the gearing ratios tell you about JKL Ltd's long-term liquidity position. (4) Examine whether high gearing can actually be beneficial to firms like JKL Ltd. 286 Theory of knowledge ‘At what time does a business decide to expand? cunt a Hee ee ai Seer Pes Mee Geese ear) Thes Pen eae Pe ect eet at ee une ean? Theory of knowledge {Js the use of quantitative data and information more, important to managers than qualitative knowledge. aims? [2marks} [3 marks} (4 marks} (6 marks)3.6 Efficiency ratio analysis Question 3.6.3 Ocean Deco Limited (Ocean Deco Limitedis a company that specalizesin the renovation of commercial properties, such as painting, decorating, repaits and maintenance of retail outlets. The company was started in 1999 by Morten Wincent and his son, who had ‘graduated from London Business School inthe same year. ‘As 2 relatively small business, Ocean Deco Limited has faced problems in securing external finance although it did ‘manage to take out an $80 000 mortgage this year to fund its expansion plans. Ocean Deco Limited has been approached. bya larger company, Shanghai Commercial Ltd, with an offer ofa takeover. Morten is reluctant to sell the family business that he helped to establish. However, his son is attracted by the lucrative deal and has advised his father that Ocean Deco Limited can no longer compete with its larger rivals that use the latest industrial tools and equipment to enhance their productivity, HIGHER LEVEL Extract from the profit and loss account and balance sheet of Ocean Deco Limited: 000 Revenue 532 Cost of sales 248 Expenses 132 Fixed assets 145 Currentassets 85 Lesscurrentliabilities 62 ‘Owners’Capital 88 Long-term liabilities 80 (a) Define the term external finance. (b) Calculate the following ratios for Ocean Deco Limited! (Gross profit margin (GPM) [2marks} (ii) Return on capital employed (ROCE) l2marks} (iti) Gearing. [2marks) {€)_ Using the above ratios, explain why Shanghai Commercial Ltd. is interested in taking over Ocean Deco Limited. 15 marks} {d) Considering both numerical and non-numerical factors, recommend to the owners of Ocean Deco Limited whether they should accept or reject the takeover bid. (7 marks) 287Section 3 Finance and accounts , Table 3.6.2 Further ratio analysis summary Stock tumover (numberof days)= -Costofagods sold ‘Average stock Or Stock turnover (number of days) = —Avetagestock 365 Cost of goods sold Stock turnover pense Debtor days= —Debtors___y 365 Debtor days Sales revenue [ficiency ratios Creditor days = ——Creditors____. 365 Creditor Creditor days Cost of goods sold —Loan capital — y 199 Capital employed Geating Question 3.6.4 ACS Playframes Limited AACS Playframes Limited (ACSPL) specialises in manufacturing and distributing children's playframes. The privately owned company, set up by Pamela Ng, employs five fulltime staffand several part-time staff. ‘ACSPL has enjoyed several years of expansion in the provision of their products to hotels, schools and local government. However, several larger foreign rivals have recently established a presence in the market. The booming economy has also. ‘meant that interest rates are on an spwards trend. Pamela has been informed by Bruce Taylor, her accountant, that the companys costs of external financing have risen dramatically. Bruce presented the following financial information for ACSPL (as of 31 March of this year) which raised some. working capital and liquity issues Costof-sales $900 000 Current assets of sales 3600000, Current liabilities 550000, Expenses $600 000, Fixed assets $7500000 Long-term liabilities $3200.000 Retained profit, $850 000 Sales revenue $3500 000. ‘Shareholders'funds '$3:500 000, (comtinued) 2881. fcontinuec) | (a) Define the term fixed assets. {b) Construct a profitand loss account for ACSPL using the figures above. (@) (Calculate the value of the current ratio. (i) Calculate the value ofthe gearing ratio. SRST ee ENA l2markst (5 marks} P2marks} marks} (li) Using your answer from part (i) and the information in the case study, explain why ACSPL is said to have'some ‘working capital and liquidity issues! f4marks) (a) Examine possible financial strategies that Pamela could use to deal with her company’s working capital and liquidity issues. Efficiency ratios and the CUEGIS concepts ‘The CUEGIS concepts were applied to profitability, liquidity and efficiency ratios in Unit 3.5. Additionally, innovations can help businesses improve their efficiency and profitability. Apple, for example, became the worlds largest company from January 2012 to April 2013 afer hugely successful product launches such asthe iPad and iPhone. By contrast, the ineficiencies and lack of profit quality of Sony has ed to its market decline ia the consumer electronics industry. Globalization alse present many business opportunities, thus having a generally postive impact on financial ratios. However, with a wider customer base across the globe, managing debiors can become increasingly difficult. Multinational companies trying to exploit the benefits of globalization will aso need finance to fund their growth, This can have a detrimental effect on theie gearing atleast in the short run, Finally it is important to be reminded that when analysing the financial performance of a business, the calculations should allyays be put inte the context of the market in which the firma operates, A gearing ratio of over 50% is perhaps acceptable to 8 large multinational company that is expanding into overseas ‘markets with huge growth potential. This maybe less acceptable 40a business that sells products in niche markets, such as hand- ‘made ukuleles. Similarly, producers of solar panel units may grant a longer credit period to property developers, whereas this is unlikely for supermarkets and retailers of fast-moving ‘consumer goods. marks} Figure 3.6a Hand-made ukuleles are niche market products, ‘A ‘high’ ROCE figure is not necessarily indicative of good business strategy either as the ratio should be compared with historical performance, inter-firm performance, interest rates offered by banks and the expected returns from alternative projects, The context also includes consideration of the ‘economic, social and political environments (see Unit 1.5) in which the business operates. Poorer liquidity is expected during a recession, for example. ‘There is also a time lag ‘between strategic implementation and the realisation of profits; this lag will vary from one indusiry to another, Nevertheless, ratio analysis can provide some invaluable information for the strategic implementation of business strategy. Consider how the CUEGIS concepts (change, culture, ethics, globalization, innovation and strategy) apply across the content discussed in this unit on efficiency ratios. 289 Ten aceea amSFr OEM MACS LLCS REVIEW QUESTIONS Gearing measures the percentage ofa firms capital employed that comes from external sources (long-term liabilities), such as 1. Whatare efficiency ratios? debentures and mortgages Firms that have at least 50% gearing axe saidto be highly geared. 2, What is meant by stock turnover? Stock turnover ratio measures the number of times a busines 3. What are the two ways to calculate the stock turnover sells its stocks within @ yea. It can also be expressed as the ratio? average number of days takes fora firm to sella ofits nocmal inventory 3 o r 4, Whats credit control and why ist important? 5. Explain whether a high or low figure is preferable for a) debtor days 1b) creditor days 6. What isthe gearing ratio? 7. How is capital employed calculated? 8. Why are highly geared firms generally considered to be risky? KEY TERMS Credit controt refers to the ability of a business to collect its debts within acuitable timeframe, Creditor days ratio is an efficiency ratio that measures the average numberof daysit takes for abusiness to pay its creditors, Debtor days ratio is an efficiency ratio that measures the average number of days it takes for a business to collect the ‘money owed from debtors. Efficiency ratios show how well a firms resources have been used, such as the amount of time taken by the firm to sell its stock (inventory) or the average number of days takento collect ‘money from its debtors. 290