What efficiency ratios are trying to show

An efficiency ratio measures how effectively a business uses its resources, assets or liabilities to support its operations. The focus here isn’t profit. Instead, these ratios look at the pace and balance of business activity: how quickly stock moves and customers pay, how long the business takes to pay suppliers, and how much it depends on borrowed finance.

Most of the figures come from the balance sheet, while cost of goods sold and sales revenue come from the profit and loss account. Ratio analysis therefore links closely to final accounts. If you can’t identify stock, debtors, creditors, long-term liabilities, share capital and retained profit, the calculations become guesswork.

Comparison of stock turnover, debtor days, creditor days and gearing ratio.

Stock turnover

Stock turnover is an efficiency ratio that measures how quickly a business sells and replaces its inventory during a period. Stock or inventory is a current asset consisting of goods held for resale or materials held for production.

One way to calculate stock turnover is to find the number of times stock is sold and replaced in a year:

$$\text{Stock turnover} = \frac{\text{cost of goods sold}}{\text{average stock}}$$

State this answer as “times per year”. A result of 8 shows that the business sells and replaces its average stock 8 times in a year.

Alternatively, stock turnover can show the number of days stock is held before sale:

$$\text{Stock turnover in days} = \frac{\text{average stock}}{\text{cost of goods sold}} \times 365$$

Give this answer in days. Multiplying by 365 converts the annual relationship into an approximate number of days. When both opening and closing stock are provided, average stock is an accounting estimate of the typical value of inventory held during the period:

$$\text{Average stock} = \frac{\text{opening stock} + \text{closing stock}}{2}$$

Industry matters when interpreting the result. A supermarket should normally turn over stock quickly because food is perishable and storage space is expensive. By contrast, a furniture retailer or specialist machinery seller may naturally keep items for longer. Faster turnover usually cuts storage costs and reduces the risk of obsolete stock. If turnover is too fast, though, the business may repeatedly run out of stock and lose sales.

Debtor days

Debtor days is an efficiency ratio measuring the average number of days a business takes to collect money from customers who bought on credit. Debtors, also called trade receivables, are current assets consisting of amounts owed to the business by customers.

$$\text{Debtor days} = \frac{\text{debtors}}{\text{total sales revenue}} \times 365$$

State the answer in days. A lower figure usually shows that customers are paying faster, which improves cash flow. Don’t interpret it mechanically, however. A business that sells expensive goods to other businesses may offer longer credit periods as a normal way of competing for customers.

A rise in debtor days can signal a problem. Sales may appear healthy on paper while the business waits too long to receive cash. Students need to remember here that profit and cash are not the same thing.

Creditor days

Creditor days is an efficiency ratio measuring the average number of days a business takes to pay money owed to suppliers. Creditors, also called trade payables, are current liabilities consisting of amounts the business owes to suppliers.

$$\text{Creditor days} = \frac{\text{creditors}}{\text{cost of goods sold}} \times 365$$

Give the answer in days. A higher creditor days figure shows that the business is taking longer to pay its suppliers. This may help cash flow by keeping cash in the business for longer. There is a limit, though. Paying too slowly can harm supplier relationships, remove early payment discounts, or cause suppliers to refuse further trade credit.

Read creditor days alongside debtor days. If customers pay in 60 days while suppliers require payment in 20 days, the business may face a cash squeeze even when it is profitable.

Gearing ratio

Gearing ratio is an efficiency ratio measuring the proportion of capital employed that is financed by long-term borrowing.

$$\text{Capital employed} = \text{loan capital} + \text{share capital} + \text{retained profit}$$

State the answer as a percentage. A highly geared business is a business in which a large proportion of capital employed comes from borrowing rather than owners’ funds. As a broad classroom rule, a gearing ratio of 50% or more is usually considered high, but 50% isn’t a magic number. The level of risk depends on interest rates, the stability of revenue, assets available as security, and the sector.

High gearing raises financial risk because interest must be paid whether profits are high or low. Shareholders may also become nervous since lenders may need more cash before profits can be distributed. Borrowing isn’t automatically bad, however. A stable business may use loan capital sensibly to expand faster than it could by relying on retained profit alone.

Improving stock turnover

A business can improve stock turnover by selling stock faster or cutting unnecessary inventory. When the ratio is measured in times per year, an increase usually shows improvement. When it is measured in days, a decrease usually shows improvement.

Possible strategies include:

• forecasting sales more accurately so orders stay closer to expected demand
• introducing just-in-time production, a stock control approach that schedules deliveries close to when materials are needed and therefore reduces stock held on site
• promoting or discounting slow-moving stock to free up cash and warehouse space
• cutting the product range when too many items sell slowly
• using better merchandising, product placement or online recommendations to help stock sell faster

There is a risk. Cutting stock too aggressively may cause stock-outs, leading to lost sales, frustrated customers and possibly a weaker reputation.

Improving debtor days

Improving debtor days usually involves collecting cash from customers sooner. This isn't simply about keeping the accounts tidy. It can affect survival, since wages, rent and suppliers usually require cash rather than promises.

Strategies include:

• carrying out tighter credit checks before customers can buy on credit
• offering customers a shorter credit period
• giving discounts for early payment
• charging interest or penalties on late payments, if the terms allow it
• issuing invoices promptly and following up overdue accounts systematically
• using debt factoring, where a business sells its trade receivables to a finance provider for immediate cash, although usually for less than the full amount owed

Stricter credit control has a trade-off: sales may fall if customers expect generous credit terms. The business should avoid improving the ratio at the unnecessary expense of good customer relationships.

Improving creditor days

With creditor days, “improvement” often means negotiating longer to pay suppliers. Longer payment periods can support cash flow. Trade credit is a short-term source of finance where suppliers let a business buy now and pay later.

Strategies include:

• negotiating longer credit terms with suppliers
• developing reliable supplier relationships so that suppliers trust the business with longer payment periods
• combining purchases with fewer suppliers to strengthen negotiating power
• scheduling payment dates carefully, allowing the business to use the full credit period without becoming overdue

This can be taken too far. Paying beyond the agreed terms may damage trust, reduce future credit, lead to legal action, or prompt suppliers to demand cash on delivery. A high creditor days figure isn't automatically positive if it suggests that the business is struggling to pay.

Improving gearing

Improving gearing usually means reducing the business’s reliance on loan capital. This becomes especially relevant when interest rates rise, profits are unstable, or lenders grow less willing to provide finance.

Strategies include:

• issuing more shares, provided the business is a company and its owners are willing to accept diluted control
• retaining more profit instead of distributing it to owners
• repaying long-term loans with retained profit
• selling underused non-current assets, then using the cash to reduce debt
• selecting sources of finance other than loans for future expansion, where appropriate

A balance still needs to be struck. Very low gearing may appear safe, yet it could also show that the business isn't using external finance to grow when a good opportunity exists. Improving a ratio isn't about pursuing the “prettiest” number. The aim is to choose a figure that makes financial sense for that business.

Strategy table for improving key working-capital and gearing ratios

Using change, context and comparison

Change runs through ratio analysis. One ratio from one year gives only a snapshot. A more useful question asks what changed, why it changed, and whether that change suits the business context.

Useful comparisons include:

• earlier years for the same business
• competitors operating in the same industry
• industry averages or norms
• the business’s own objectives and strategy

For a fashion retailer, a rise in stock turnover days could be worrying because trends move quickly. Yet the same rise may be acceptable if a business deliberately purchased extra raw materials ahead of an expected supplier shortage. Context isn't decoration in ratio analysis; it is the analysis.

Insolvency

Insolvency is the financial state in which a person or business can’t pay debts when they fall due. The crucial issue is timing: the debts cannot be paid on time. A business may look profitable on paper yet still become insolvent because too much revenue is tied up in debtors, slow-moving stock or other non-cash items.

The ratios above link directly to this risk. High debtor days suggest that customers are holding the business’s cash, while high stock turnover days suggest that cash is stuck in inventory. If gearing is very high, fixed interest payments still have to be met—even when trading is weak.

Bankruptcy

Bankruptcy is a legal process through which the courts or other legal authorities formally deal with an insolvent person and, in some jurisdictions, a business. Business language also uses liquidation: the legal process of selling a company’s assets and using the proceeds to pay creditors as far as possible.

The distinction is straightforward but important. Insolvency is the financial problem; bankruptcy is a legal process that may follow. Don’t treat the two words as identical.

Why the distinction matters to stakeholders

For managers, insolvency signals the need for urgent action. They may collect debts faster, sell excess stock, negotiate with creditors, reduce costs or raise finance. Lenders and suppliers face a greater risk of not being paid. Employees may lose job security, while owners risk losing both their investment and control.

Bankruptcy or liquidation is more formal and usually more severe. Once legal proceedings begin, decision-making may pass from managers to administrators, courts or appointed specialists. Assets may then be sold quickly to raise cash, often for less than their ideal value.

Efficiency ratios aren’t just “calculation ratios”; they act as early warning signals. When they move in the wrong direction and management does nothing, a cash flow problem can turn into insolvency, followed by legal collapse.