Efficiency ratios help assess how effectively a business uses its resources in managing day-to-day operations. They provide crucial insights into how well a business is managing its stock, paying its suppliers, and collecting debts from customers. By analysing these ratios, businesses can identify operational strengths and weaknesses, improve financial management, and maintain a healthy cash flow.
Inventory Turnover
Definition
Inventory turnover is a financial efficiency ratio that shows how many times a business sells and replaces its inventory over a specific period, usually a year. It reflects how efficiently a company manages its stock and how well its products are selling. Efficient inventory management reduces costs related to storage and waste, while poor inventory turnover may result in obsolete stock and tied-up capital.
Formula
Inventory turnover = Cost of sales ÷ Average inventories
Cost of sales: Also known as cost of goods sold (COGS), this includes all direct costs related to the production of goods that have been sold by the business, such as materials and labour.
Average inventories: This is calculated by taking the opening stock and closing stock for the period, adding them together, and dividing by two:
Average inventories = (Opening inventory + Closing inventory) ÷ 2
Purpose
This ratio shows how often inventory is "turned over" or sold during the period.
It is especially important for businesses with significant stock levels, such as retailers or manufacturers.
A high turnover rate typically indicates strong sales and efficient inventory management.
A low turnover rate can be a warning sign of slow-moving stock, excessive inventory, or falling demand.
Interpretation
High inventory turnover:
Suggests the business is selling stock quickly.
Can be a positive sign of effective stock control and strong demand.
However, if too high, it might indicate that the business is not keeping enough inventory to meet demand, potentially leading to lost sales and dissatisfied customers.
Low inventory turnover:
Indicates the business is not selling inventory quickly enough.
May be caused by overstocking, poor sales, or purchasing errors.
Could result in higher storage costs and risk of stock becoming obsolete or spoiling (especially in perishable goods industries).
Application and Context
For a supermarket, a high inventory turnover is common and expected due to fast-moving goods.
For a furniture store, lower turnover may be acceptable as products are more expensive and sell less frequently.
Trend and Benchmark Analysis
Compare inventory turnover over multiple periods (e.g. quarterly or annually) to identify changes in efficiency.
Compare to industry averages or direct competitors to evaluate performance.
Investigate significant changes in turnover to identify causes and address potential problems.
Limitations
Seasonal businesses might show misleading turnover ratios if calculated over a short period. Use annual figures or compare equivalent seasonal periods.
Product type matters – some businesses naturally have slower turnover due to the nature of goods sold.
Inventory valuation methods (FIFO, LIFO) can impact cost of sales and affect the ratio.
Payables Days
Definition
Payables days (also known as creditor days) is a liquidity ratio that measures the average number of days a business takes to pay its suppliers. This ratio helps assess the effectiveness of the business’s payment practices and short-term financial strategy.
Formula
Payables days = (Payables ÷ Cost of sales) × 365
Payables: The amount the business owes to its suppliers at the end of the period, shown as a current liability on the balance sheet.
Cost of sales: Used to approximate the total purchases made during the period.
The multiplication by 365 converts the ratio into days, giving an average time frame.
Purpose
Reveals how long it takes a company to pay its suppliers on average.
Affects relationships with suppliers and impacts cash flow management.
Indicates the company’s bargaining power and financial discipline.
Interpretation
Higher payables days:
Suggests the business is taking longer to pay its suppliers.
Can be good for cash flow, as it delays cash outflows.
However, it may damage supplier relationships or result in the loss of early payment discounts.
Lower payables days:
Implies the business pays its bills more quickly.
May strengthen supplier trust and lead to better trade terms.
Could put pressure on cash reserves if not managed well.
Industry Differences
A wholesaler may negotiate longer payment terms, leading to higher payables days.
A retail store might have shorter payment cycles and thus lower payables days.
Trend Analysis and Use
Monitor changes in payables days year-on-year to identify shifts in supplier payment policy or cash management.
Compare with supplier terms – if payables days exceed the agreed terms, it could lead to disputes.
Evaluate alongside receivables days to assess working capital strategy.
Limitations
May not reflect the diversity of payment terms – one supplier might offer 60 days while another only 15.
A very high payables period could indicate financial difficulty rather than a strategic delay.
Assumes all purchases are on credit, which may not be accurate.
Receivables Days
Definition
Receivables days (also known as debtor days) is a financial efficiency ratio that shows the average number of days it takes for a business to collect payments from its customers after a sale is made on credit.
Formula
Receivables days = (Receivables ÷ Revenue) × 365
Receivables: The amount owed by customers for goods/services delivered on credit. This appears as an asset on the balance sheet.
Revenue: The total sales made during the accounting period.
Purpose
Measures the effectiveness of the company’s credit control and collection policies.
Highlights how long capital is tied up in unpaid invoices.
Influences cash flow and the business’s ability to meet financial obligations.
Interpretation
Higher receivables days:
Indicates customers are taking longer to pay.
May point to lenient credit terms, poor collection practices, or customer dissatisfaction.
Ties up cash and increases risk of bad debts or write-offs.
Lower receivables days:
Means customers pay quickly.
Improves cash flow and reduces credit risk.
Could suggest strict credit terms, but might deter potential customers in competitive markets.
Practical Examples
A construction company might naturally have longer receivables days due to milestone-based payment structures.
A coffee shop, operating mostly on cash sales, would have very low or zero receivables days.
Trend Monitoring and Benchmarking
Identify whether receivables days are increasing or decreasing over time.
Evaluate efficiency in collecting payments compared to competitors.
Assess if credit policies need tightening or if additional credit checks are necessary.
Limitations
Averages can hide outliers – one or two large unpaid accounts may distort the figure.
Revenue includes all sales, not just credit sales – can skew results if many transactions are cash-based.
Doesn’t reveal the age profile of debts (how many are very overdue vs just slightly late).
Overall Use of Efficiency Ratios
How They Reflect Operational Efficiency
Inventory turnover reflects stock management and product demand.
Payables days indicates how a business manages its obligations to suppliers.
Receivables days reflects customer payment behaviour and credit policy effectiveness.
Combined, these ratios paint a picture of how well the business manages the core components of its working capital – the money tied up in day-to-day operations.
Identifying Strengths and Weaknesses
Efficiency ratios can reveal:
Whether a company holds too much stock (low inventory turnover).
If it takes too long to collect payments (high receivables days).
If it is delaying supplier payments too long (very high payables days).
If it is struggling with cash flow due to inefficient operations.
Evaluating Trends and Decision-Making
Efficiency ratios are most useful when analysed over time or against competitors. For example:
A rise in receivables days could mean the business is offering longer credit to attract sales, but this could strain cash reserves.
A drop in inventory turnover could mean products are not selling or purchasing has increased unnecessarily.
An increase in payables days might mean the business is preserving cash or facing liquidity pressures.
Strategic Use
Businesses use efficiency ratios to inform decisions such as:
Adjusting pricing or discount policies.
Re-evaluating supplier contracts.
Implementing stricter credit control policies.
Reducing inventory levels to free up cash.
Efficiency Ratios and Financial Health
While not definitive, efficiency ratios are a vital component of assessing financial health. They help answer key operational questions such as:
Are we managing our resources wisely?
Are we being paid on time?
Are we paying others on time?
Are we holding too much stock?
Limitations of Efficiency Ratios
They rely on historical figures and may not reflect current trends or future prospects.
They can be manipulated through changes in accounting policies or cut-off timings.
External factors, such as economic conditions or supply chain disruptions, may distort figures temporarily.
Efficiency ratios do not account for qualitative aspects, such as customer satisfaction, employee productivity, or product quality.
Nonetheless, when used in context and interpreted alongside other financial and non-financial data, efficiency ratios provide valuable insights that can guide effective business strategy and operational improvements.
FAQ
A business might choose to maintain a lower inventory turnover to ensure product availability, reduce the risk of stockouts, or take advantage of bulk purchasing discounts. This approach is common in industries with unpredictable demand or long lead times, where having buffer stock helps maintain service levels. Luxury retailers may also prefer lower turnover due to higher margins and longer product lifecycles. Although less efficient in terms of capital use, it can support brand positioning or customer satisfaction in specific sectors.
Efficiency ratios are heavily influenced by external industry conditions such as inflation, supply chain disruptions, or shifts in consumer behaviour. For instance, rising material costs may delay purchasing, affecting inventory turnover. A slowdown in customer payments during economic downturns can increase receivables days. Technological advancements may improve stock control and increase turnover. Therefore, changes in the industry context must be considered when interpreting these ratios, as fluctuations may result from environmental factors rather than poor internal management.
Credit terms directly affect both receivables and payables days. If a business offers extended credit terms to customers (e.g. 60 days), it will likely experience higher receivables days, delaying cash inflow. Conversely, negotiating longer payment terms with suppliers increases payables days, delaying cash outflow. Managing these terms strategically is crucial for working capital. An imbalance—such as short customer terms and long supplier terms—can strain cash flow and reduce operational flexibility. Strong credit control ensures that terms align with the business’s financial capacity.
While efficiency ratios are primarily used to analyse internal operations, trends in payables days can indirectly indicate supplier performance. For example, consistently low payables days may reflect pressure from suppliers to pay quickly, possibly due to unreliable service or poor relationships. Conversely, long-standing, trusted suppliers may offer extended terms, contributing to a higher, healthier payables figure. However, for a full assessment of supplier reliability, qualitative factors such as delivery times, quality, and communication are also essential alongside financial ratios.
Efficiency ratios inform broader strategic decisions such as investment planning, pricing strategies, and supplier negotiations. For instance, a declining inventory turnover may prompt the business to reduce product lines or invest in just-in-time systems. Rising receivables days might lead to a change in credit policy or investment in accounts receivable software. Consistent efficiency helps maintain strong liquidity, supporting long-term growth decisions. Lenders and investors also scrutinise these ratios when evaluating operational discipline, making them vital for strategic credibility and access to finance.
Practice Questions
Analyse how efficiency ratios could help a business improve its working capital management.
Efficiency ratios such as inventory turnover, payables days, and receivables days provide valuable insights into how effectively a business manages stock, supplier payments, and customer debts. For example, a high receivables days figure may indicate weak credit control, prompting the business to tighten credit terms or improve collection methods. Similarly, a low inventory turnover may lead to reviewing stock management to reduce holding costs. By interpreting these ratios, a business can adjust operational policies to reduce cash tied up in current assets or liabilities, ultimately improving liquidity and optimising working capital management for better financial stability.
Explain one possible drawback of using receivables days as a measure of financial efficiency.
A key drawback of using receivables days is that it only provides an average and does not reveal the age profile of outstanding debts. This means a business could have a low average receivables figure while still having a few significantly overdue accounts, which could pose serious cash flow risks. Additionally, the ratio includes all revenue, even if a significant portion is cash sales, leading to misleading results. Therefore, receivables days may not fully reflect the effectiveness of credit control or the real payment behaviour of customers, reducing its reliability as a standalone indicator of financial efficiency.
