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/ 12
Chapter 19
Unit 3.6 - Efficiency ratio analysis (HL only)
“A.good decision s based on knowledge and not on numbers”
-Plato (427 - 347 BC), Greek philosopher
Contents
Efficiency ratio analysis (HL only)
HL content
Depth of teaching
‘The following efficiency ratios:
+ stockturnover
+ debtordays
+ creditor days
+ gearing ratio
Possible strategies to improve these ratios
‘802,404
03,
Insolvency versus bankruptcy
02
1©180, 2022
analysis
‘The fllowing effikency ratios: () stock turnovey, i) debtor days,
{ut ereettor days and (wv) gearing ratio. A02, AD
Possible sateges to improve these ratios. AOS
‘180, 2022
the vakue of afirsliablitiesand debtsagainstits equity.
‘These ratios (sometimes referred to as debt and equity
ratios) are a measure of the financial stability ofthe business
“These ratios show how eliciently an organization’ resources
have been used, such as the amount of time taken by the
business 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 haxury jewellers sell t
goods. There are four main additional ratios for HI. students to
learn: (i) stock tumover, (i) debtor days, (i) creditor days and
the (iv) the gearing ratio.
Ts: of efficiency ratiosenablesa business to calculate
(i) Stock turnover
‘The stock turnover ratio (or inventory turnover ratio)
‘measures the number of times an organization sells its stacks
within a time period, usually one year. The ratio therefore
indicates the speed at which a business sells and replenishes
all its stock. There are two alternative ways to calculate stock
turnover:
‘Stock turnover (number of times) = Cost of sales_
‘Average stock
or
‘Stock turnover (number of days) =
—Average stock _ 36
Cost of sales
287 Topic 3: Finance and accounts
Dice aaa)
“The second method expresses stock turnover in term of the
average number of days it takes for « business to sell all ofits
inventory,
‘When looking at stack turnover, the cost of sales is used (rather
than sales turnover) as stocks are valued atthe costvalue ofthe
inventory to the business rather than the selling price to the
customer. For example, ifa business has cost of sales equal to
$100,000 and an average stock level valied at $20,000 then the
stock turnover ratio:
+ $100,000 / $20,000
times a year or
+ ($20,000 / $100,000) « 365 = 73 days.
“This means that the business sells all ofits inventory, which is
then replenished, five times a year arevery 73rd day, on average.
Using the frst calculation, the higher the ratio the better itis
for the business because more stock is sold and therefore the
more elficient itis in generating profit, A high stock turnover
also means that perishable stocks, such as fresh milk or freshly
baked cakes, do:not expire or stocks do not become out of dated,
By contrast a lower number is better when using the second
calculation, as 73 days to replenish stocks is highly undesirable
for businesses dealing with perishable products,
Figute 19.1 Firms that sell perishable products need to
havea high stock turnover rate
“There are several ways that an organizations 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 Chapter 40).
288
+ Divestment (disposal) of stocks which are slow to sell i.
{getting rid of obsolete stock and unpopular products in the
firms portfolio,
+ Reducethe range ofproducts 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 (by
times) than a seller ofluxury motor vehicles. A stock turnover
rate of 6 times a year is perhaps acceptable to suppliers of
consumer durables, but unacceptable toa florist or fresh fish
‘monger. Hence, a low stock turnover ratio Is not necessarily a
bad sign: all ratios must be put into context.
{ii) Debtor days
‘The debtor days ratio measures the aumber of days it takes a
business, on average, to collect money from its debtors. Hence,
tis sometime referred to asthe debt collection period. Debtors
are the customers who have purchased items on trade credit
and therefore owe money to the business. It is calculated using
the formula
Debtor days = ——Debtors_ x 365
Total sales revenue
‘where total sales revenue is an approximation of the firm's
total credit sales
For example, if an organization's debtors (shown on its balance
shect) totals $1 million whilst its sales turnover is $5 million,
then the debtor days ratio i: (Sim / $Sm) x 365 = 73 days.
‘This meansit takes the business an average of 73 days ta collect
debts from its customers who have bought items on credit.
Logically, the less time it takes for customers to pay their debts,
the better it s for the business, There are two reasons for this
first, the business improves its cash flow if customers pay on
ume and second, due to the opportunity cost of holding onto
‘money, the business could lnvest this money in other revenue-
{generating projects. However, a debtor days ratio that is too
high or too low can also be problematic: ERM ite US Ar COrUE INES a ob)
+ Although businesses may allow customers to buy on credit,
itis important that the credit period granted isnot too long,
otherwise the businesses could face liquidity problems (see
‘Chapter 20).
+ Equally, too low a debtors day ratio suggests customers
‘may seek other suppliers if the credit period given to them
‘is uncompetitive hecause clients prefer better credit terms
kis quite common to allow customers between 30 to 60 days
credit. The organization’ ability to collect debts within asuitable
timeframe is known as eredit 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 thelr bils
late, In a similar way, in many countries, the government
‘will impose a surcharge on income tax bills fr late payers.
+ Give debtors incentives to pay earlier, such a giving a
discount to those who pay their bills before the due date,
Many businesses encourage their credit customers to use
direct debit or autopay. These are financial services that
involve transferring money owed to creditors by using
funds directly from the clients banks account on designated,
days. This saves customers having to remember when to.
pay thelr bills and hence avold penalties for late payments.
+ 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 legal action. The threat of taking a customer to
‘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
bbusinessesit is more acceptable to have a higher debt collection.
period. Fast food restaurants or bur salons, on the other hand,
have customers paying for their goods at the time of purchase
so their debt collection period would be much lower
Figure 19.2- Suppliers of luxury goods, such as yachts, rely
on credit sales
(iii) Creditor days
“The creditor days ratio measures the number of days it takes,
‘on average, fora business to payits trade creditors. The formula
for this ratio is:
Creditors
Cost of sales|
Creditor days 365
Where cost of sales is an approximation ofthe firms total
credit purchases
For example, if business has $225,000 oved to its suppliers
(as seen from its balance sheet) sith $2 million worth of cost
‘of sales (or cost of goods sold), then the creditor days ratio is
(525,000 / 82m) x 365=41 days. This means the business takes
441 days on average to pay its suppliers, Itis common to provide
‘customers with 30-60 days credit, soa creditor days ratio in thi
range would generally be seen to be acceptable.
Ahigh 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 creditor days ratio. might
also mean thatthe business is taking too long to pay its trade
creditors so suppliers may impose financial penalties for Inte
payment. In this case, a high creditor days ratio will harm the
firnis cashflow position.
289, Topic 3: ance and accounts
or nay
In theory, the efficiency position ofa business can be enhanced
by improving any ofits efficiency ratios, Le, increasing stock
turnover, reducing debtor days and increasing creditor days.
Strategies to achieve this include:
+ Developing closer relationships with customers, suppliers
and creditor, thereby helping to reduce the debt collection
time and extend the credit period.
+ Tatroduce a system ofjust-in-time production (see Chapter
37) 10 eliminate the need to hold large amounts of stocks
and to improve stock contol
+ Improve credit control, ie., managing risks regarding 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 bad debts (money owed to the
business that does not get repaid).
{iv) Gearing ratio
“The gearing ratio is used to assess an organization’ long term.
liquidity position. This is done by examining the firms capital
employed that is financed by long term debt (non-current
liabilities), such as mortgages (see Chapter 14). The gearing
ratio enables managers to gauge the level of efficiency in the use
‘of an organization’ capital, The gearing ratio formula is:
Question 19.1
Gearing ratio - —Non-currenttlabilties 499
Capital employed
or
Gearing ratio = —Loancanital__ 100
Capital employed
where capital employed = Non-current liabilities + Equity
For example, a business with non-curvent abilities totalling $5
million whilst its capital employed is $15 million has a gearing
ratio of (85m /$15m) x 100= 33.3%, This means that one third
‘of the organizatioris sources of finance comes from external
interest-bearing funds, whilst the other two-thirds represent
internal sources of finance, Recall from Chapter 18 that capital
‘employed is comprised of the fim’ loan capital (non-current
abilities) and equity (share capital plus retained earnings).
“The higher the gearing ratio, the larger the firmis dependence
‘on long term sources of borrowing (as shown by the value of
nnon-current liabilities on the balance sheet). This means that
the business incurs higher costs due co debt financing, such as
interest repayments to banks or debenture holders (see Chapter
15). This can therefor limit the overall profit for the business.
Creditors and investors are interested in the level of gearing of
‘a business. A firm is said to be highly geared i thas a gearing
ratio of 509% or above, Such businesses are more vulnerable
a) Use Tables 18.1 and 18.2 to calculate the following ratios for KL Ltd, for both years:
(stock turnover,
{i debtor days and
(iy creditor days.
{(b)_ Using your answers from part (a) above, explain the efficiency position of JKL Ltd.
(€)_ Examine the ways in which JKL Ltd, could improve its efficiency position,
290
[2marks}
marks}
{marks}
marks} to increases in interest rates, ‘This situation is similar to. an
individual who has a large mortgage with @ bank. A rise in
interest rates will mean such individuals will have higher
_monthly interest repayments on their outstanding mortgages.
Simllaly, a highly geared business will be more exposed to
terest rate hikes or if there isa downturn ia the economy as
Joan repayments remain high whilst cash inflow from sales will
tend tofall ina recession, Other financiers are les likely to Tend
‘money to firms that are already highly geared due to their lange
Joan commitments
Shareholders and potential investors are also interested in
the gearing ratio as it helps to assess the level of risk. Since
financiershave to be repald first (with intrest), tis may reduce
the amount paid to shareholders and the amount retained for
reinwestments. However, ifthe profitability of the business
Js igh (see Chapter 18), then potential returns can be very
attractive even in high 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, ever if this raises the
level of gearing, The issue is how much debt the business can
handle before the benefits of growth outweigh the costs of
higher gearing and exposure to financial risks, The level of
‘gearing that is acceptable to a business will depend on several
factors including
+ ‘The size and status of the business - Generally, there is a
positive correlation between a firms size and status and ts
ability to repay long term debts. Most stakeholders would
‘not worry too much if McDonalds or Walmart had a
_geating ratlo of 30% as it Is likely to be able to repay the
debt.
Question 19.2
(@) Calculate the gearing ratio fr KL Ltd. for both years.
(b) Explain what the gearing ratios tell you about JKL Ltd's long-term liquidity position.
(6) S.amine whether high gearing can actually be beneficial to organizations like JKL Ltd,
ERM ACCOR UC NEA moe)
“The level of interest rates - IF interest rates are low, then
businesses are less vulnerable (at least in the short term)
‘even with a high gearing ratio. For example, the 2008
{global financial crisis caused many governments across the
world to reduce interest rates close to zero percent. This
‘minimises the interest repayments on long term external
finance,
Plea aa)
Potential profitability - businesses have good profit quality
(long term prospects of earning profit), then high gearing
isles Likely to bean issue. This applies to many businesses
in bigh-tech industries that invest heavily in research and
development. They may need external finance to fan the
‘expenditure on R&D but the potential for high returns can
minimise their exposure to gearing,
Theory of Knowledge (TOK)
‘At what time does a business know or decide to
‘expend?
Theory of Knowledge (TOK)
To what extent can managers rely on data and
Information from the past to inform decision making
about the future?
marks}
(4 marks}
16 marks}
201 Topic 3: Finance and accounts
Ce ea
Question 19.3 - Ocean Deco Limited
‘Ocean Deco Limited isa company that specializes in the renovation of commercial properties, such as painting, decorating,
repairs and maintenance of retail outlets, The company was started in 2009 by Chris DelPreore and his son, who had
‘graduated from London Business School in the same year.
‘Asa 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 by a
larger company, Vintage Commercial Ltd, with an offer ofa takeover. Chris DelPreoreis reluctant to sell the family business
that he helped to establish, However, his son i 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 theie
productivity.
etact from the profit and loss account and balance sheet of Ocean Deco Limited:
s'000
Sales revenue 532
Cost of sales 248
Expenses 132
Non-curtent assets 145
‘Current assets 5
Current liabilities 2
‘Owners'capital 88
Long-term liabilities 80
(a) Define the term external finance. 2marks}
(8) Calculate the following ratios for Ocean Deco Limited:
(Gross profit marin (GPM) marks}
)) Return on capital employed (ROCE) 2marks}
(i) Gearing. marks}
(€)_ Using the above ratios, explain why Vintage Commercial Ltd. might be interested in taking over Ocean Deco Limited.
4 marks}
(4) Considering both numerical and non-numerical factors, recommend to the owners of Ocean Deco Limited whether
‘they should accept or reject the takeover bid. Omarks)
292 3.6 Efficiency ratio analysis (HL only)
Table 19.1-Effic pe ysis summary table
z
—Costofsales o-—_Averagestock
stock turnover x365 >
‘Average stock Cost of sales if
£
Debtor days Debtors x 365 ry
Total sales revenue o
=
Creditor days Creditors. 365
Cost of sales
Gearing Non-currentliabilties 499
Capital employed
Question 19.
ACS Playframes Limited
AACS Playframes Limited (ACSPL) specializes in manufacturing and distributing children’s play frames. The privately held
company, set up by Pamela Ng, employs 5 full-time staff and several part-time staff
ACSPL has enjoyed several yeats of expansion in the provision of their playframes to hotels, schools and the local
government. However, several larger foreign rivals have recently established a presence in the matket. The booming
economy has also meant that interest rates are on an upwards trend.
Pamela has been informed by Alka Hingle, her accountant, that the company's costs of external financing have risen
‘dramatically. Alka presented the following financial information for ACSPL (as of 31st March of this year) which raised some
‘working capital and liquidity issues:
Cost of sales $900,000
Current assets $600,000
Current liabilities $550,000
Expenses $600,000
Fixed assets $7,500,000
Non-current liabilities $3,200,000
Retained profit $850,000
Sales revenue $3,500,000
Shareholders'funds $3,500,000
(a) Define the term non-current liabilities.
(b) Construct profit and loss account for ACSPL using the figures above. [4 marks}
(©) {Calculate the value of the current ratio. [2marks)
(i) Caleulate the value of the gearing ratio. [2marks}
{ii)_Using your answer from part (c)(] and the information in the case study, explain why ACSPL is said to have
‘some working capital and liquidity issues: (4 marks}
(€) Examine two financial strategies that Pamela could use to deal with her company’s working capital and liquidity
Issues. 16 marks}
293 Plc aaa)
Elekta icy
Insolvency versus bankruptcy
(AO2)
mnsolvency occurs when individuals (such as sole traders
and partners) or organizations as legal business entities are
sonable to settle their debts when they are due because of
the lack of funds or cash in their bank accounts. This occurs
mainly due to one of two reasons:
+ Cash flow insolvency - This occurs when an insolvent firm
cannot make a payment owed to creditors because it does
not have the cash to da so.
+ Balance sheet insolvency - This occurs when the liabilities
(debts) ofthe firm exceed its assets
“There are several solutions for resolving insolvency, such as
borrowing money (although this might depend on the firm's
existing gearing rato), cutting costs or selling off non-current
assets in order to raise funds to pay off the debts, Firms might
also be able to negotiate a debt payment or settlement plan with
their creditors, although this is likely to damage their future
credit ratings.
By contrast, bankruptey is the formal and legal declaration
of an individuals or organizations inability to settle its debts.
‘This means thatthe business owes so much that selling all its
assets will not cover the debts owed. Hence, the business has
failed and is unable to continue trading. Bankruptcy isa last
resort and occurs when all attempts to tackle insolvency have
failed. At the end of the bankruptcy period, any outstanding
4ebis ofthe businessare terminated and creditors can no longer
demand payment, charge interest or take further Tegal action
294
against the firm. However, bankruptcy can severely damage the
credit rating ofthe owners of a busines, hindering their ability
to borrow money for many years ahead.
So, a business can be insolvent without being bankrupt, but it
‘cannot go bankrupt without first being insolvent. Insolvency
financial state that a business might find itself in, whereas
bankruptcy is a legal declaration and process involving
individuals or firms unable to pay off thelr debts. In legal
terms, insolvency applies to individuals and corporations,
‘whereas bankruptcy applies to individuals only. In both cases
though, as insolvent and bankrupt businesses are prone to
‘experience financial difficulties, they may be taken over by
larger competitors.
“To understand these to ideas, it is important to look at the
firm liquidity position and its working capital cyle
“The term liquidity refers to bow easly an asset can be turned
into cash, Highly liquid assets ate those that can be converted
into cash quickly and easily without losing their monetary
value, such as cash deposits at a bank. Raw materials, on the
other hand, would be relatively illiquid current assets as they
‘cannot be changed into cash as easily oF quickly.
Evidence from around the world consistently shows that
insufficient working capital (the difference between a firms
‘cartent assets and its current liabilities) is the single largest
‘cause of business failure, rather than a lack of profitability,
Tnadequate working capital leads to insolvency. This can lead
to the collapse of the business as creditors will take legal action
to recaver their money: This can trigger the liquidation of the
business, ie, it will ned to sell ofits assets to repay as much of
the money owed to its creditors.
‘Working capital (or net current assets) Is calculated using the
formula:
‘Working Capital = Current Assets ~ Current Liab
‘Current assets arc the liquid resources belonging toa business
that are expected to be converted to cash within the next twelve
‘months. The three main types of current assets are cash, stocks
and debtors (see Chapter 17). Current liabilities refer to the
money that a business owes that needs to be repaid within
the next twelve months. These include bank overdrafts, trade
