Efficiency Ratios

Ratios

Under the syllabus, efficiency ratios consist of two main ratios, the debtor's collection period and the inventory turnover.

Inventory Turnover

Inventory turnover period measures the amount of times cost of sales exceeds average inventory.

Calculation of Average Inventory

Average inventory is simply the sum of the opening balance of inventory and the closing balance of inventory divided by 2.

Interpretations

Acceptable ratio levels are dependent on each industry; therefore, inventory turnover ratios should be compared to industry averages as well as past performance.

Generally speaking, the usual interpretations are:

Low

Bad – as the business is not selling enough inventory, increasing the risk of a devaluing of inventory due to obsolescence.

High

Good – as the business is selling a lot of its inventory, decreasing the risk of obsolescence.

Handy Tips:

Think about the industry – You can extend an answer by stating how the inventory turnover directly impacts the type of business. For example, if the business was a supermarket, a low inventory turnover would increase the chance of perishable food becoming out of date and expired.
Check the discount allowed – Has the business created a higher demand for inventory by giving discounts? (Sign of bad inventory management)

Debtor’s Collection Period

Debtor’s Collection Period measures the average time it takes to receive payments from creditors.

Calculation of Average Debtors

Average debtors considers the average amount of accounts receivable over an accounting period. To calculate average debtors, add the sum of the initial accounts receivable value and the closing accounts receivable value and divide that sum by 2.

Note: Net Credit Sales

Net – means remove the sales returns figure from the amount.

Interpretations

Acceptable ratio levels are dependent on each industry; therefore, quick asset ratios should be compared to industry averages as well as past performance.

Generally speaking, the usual interpretations are:

Low

Good – as it means debtors pay their amounts owning quickly.

High

Bad – as it means debtors take a long time to pay its debts.

Handy Tips:

Check the discount allowed – Has the business increased its debtor’s collection period by giving out generous discounts (Sign of bad accounts receivable management)