Efficiency Ratios (Cambridge International IGCSE Accounting)
What are efficiency ratios?
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Efficiency ratios are ways to measure how efficient a business is at managing processes linked to buying and selling goods
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They compare trade receivables, trade payables and inventory with credit sales and purchases and the cost of sales
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They indicate how efficient a business is at
- Receiving payments from customers
- Making payments to suppliers
- Selling its inventory
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The efficiency ratios are:
- Rate of inventory turnover
- Trade receivables turnover
- Trade payables turnover
Rate of inventory turnover
What is the rate of inventory turnover?
| What is the formula? | |
|---|---|
| How should the value be written? | Write as the number of times per year (X times) |
| How should the value be rounded? | Round to two decimal places |
| What does the value mean? | The value represents the number of times a business is able to fully sell and replace its inventory in a year |
| How can the ratio be improved? | - Increase the volume of sales - Reduce the amount of inventory that is held by the business |
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It can be easier to think of the rate in terms of how long it takes for a business to fully sell its inventory without replacing it
- If the rate of inventory is 2 then this means it takes the business half a year to fully sell its inventory without replacing it
- You can divide 365 days by the rate to find the number of days it takes to fully sell the inventory without replacing it
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A business aims to sell its inventory quickly
- This prevents the inventory from going out of date or out of season
Worked Example Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.
$ Sales 40 000 Purchases 25 000 Inventory at 1 March 2023 7 000 Inventory at 29 February 2024 9 000 Calculate the rate of inventory turnover for the year ended 29 February 2024. The calculation should be correct to two decimal places.
Answer:
Calculate the cost of sales
- Opening inventory + Purchases - Closing inventory
$7 000 + $25 000 - $9 000 = $23 000
Calculate the average inventory
\frac{\ 7 000 + $ 9 000}{2} = $ 8 000$
Calculate the rate of inventory turnover
- Round to two decimal places
Final answer: Rate of inventory turnover = 2.88 times
Trade receivables turnover
What is the trade receivables turnover?
| What is the formula? | |
|---|---|
| How should the value be written? | Write as the number of days (X days) |
| How should the value be rounded? | Round up to the next whole day |
| What does the value mean? | The value represents the average number of days it takes a business to receive full payment for goods sold to credit customers |
| How can the ratio be improved? | - Encourage credit customers to pay quickly - Offer cash discounts - Charge interest for late payments - Reduce the amount owed by customers - Enforce a credit limit - Require a cash deposit |
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A business will aim to receive payment from customers as quickly as possible
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A business might offer credit to customers:
- To get ahead of the competitors
- To potentially receive larger orders from customers
Worked Example Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.
$ Sales 40 000 Trade receivables 11 000 All sales were made on a credit basis.
Calculate the trade receivables turnover for the year ended 29 February 2024. Round up your answer to the next whole day.
Answer:
Calculate the trade receivables turnover
- Round up to the next whole day
Final answer: Trade receivables turnover = 101 days
Trade payables turnover
Spec point —
6.4.3
What is the trade payables turnover?
| What is the formula? | |
|---|---|
| How should the value be written? | Write as the number of days (X days) |
| How should the value be rounded? | Round up to the next whole day |
| What does the value mean? | The value represents the average number of days it takes a business to fully pay for goods purchased from credit suppliers |
| How can the ratio be increased? | - Take advantage of any interest-free periods - This helps the business keep their cash for as long as possible in case of emergencies |
| How can the ratio be decreased? | - Pay for goods using cash when possible - Pay invoices quicker |
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There are benefits to paying for goods using credit:
- The business can keep its cash for as long as possible in case of emergencies
- The business can wait until it receives payment from customers before paying its suppliers
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There is no optimal value for the trade payables turnover
- The value should not be too high otherwise the business might be charged interest or late fees
- The value should not be too low otherwise the business will have a low working capital
Worked Example Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.
$ Purchases 25 000 Trade payables 4 000 All purchases were made on a credit basis.
Calculate the trade payables turnover for the year ended 29 February 2024. round up your answer to the next whole day.
Answer:
Calculate the trade payables turnover
- Round up to the next whole day
Final answer: Trade payables turnover = 59 days
Evaluating efficiency
How do I evaluate the efficiency of a business?
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Look at all the efficiency ratios together
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The rate of inventory turnover tells you how quickly the business can sell its inventory
- The higher the rate, the better the liquidity of the business
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Look at the difference between the trade receivables turnover and trade payables turnover figures
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It is better if the trade receivables turnover is lower
- This means the business receives money from its credit customers before paying its credit suppliers
- This helps with the liquidity of the business
- The difference between them is then the number of days that the business has the money from the customers before paying the suppliers
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If the trade receivables turnover is higher:
- The business pays its suppliers before receiving money from its customers
- This could result in the business taking out short-term loans to pay its suppliers
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How do I compare the efficiency of a business over the years?
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Compare the ratios to the same ratios from previous years
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For each ratio
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Make a general comment
- State whether it has improved or gotten worse
- State the ratios
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Give possible reasons for the change
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Look at the difference between the trade receivables turnover and the trade payables turnover
- Comment on the difference
Worked Example Odin is a sole trader and his financial year ends 31 October. He provides the following information.
Year ended 31 October 2022 31 October 2023 Rate of inventory turnover 8.25 times 10.40 times Trade receivables turnover 35 days 27 days Trade payables turnover 20 days 28 days (a) Explain why Odin is satisfied with the change in the rate of inventory turnover.
(b) Suggest two reasons for the decrease in Odin's trade receivables turnover.
(c) Suggest two reasons for the increase in Odin's trade payables turnover.
Answer:
(a)
- State the benefits of having a higher rate of inventory turnover
Final answer: The rate of inventory turnover has improved by increasing from 8.25 times to 10.40 times. This means Odin sold his inventory at a faster rate than the previous year. This has improved the liquidity of the business as Odin is able to convert assets into cash more quickly.
(b)
- Give two reasons why the trade receivables turnover might decrease
Final answer: On average, Odin is receiving payment from his credit customers 8 days faster.
Final answer: One possible reason is that Odin has started to offer cash discounts for early repayment.
Final answer: Another possible reason is that Odin has increased the amount of interest that is charged on overdue balances.
(c)
- Give two reasons why the trade payables turnover might increase
Final answer: On average, Odin is paying his credit suppliers 8 days slower.
Final answer: One possible reason is that Odin has less available cash to pay his suppliers as promptly.
Final answer: Another possible reason is that the suppliers are no longer offering cash discounts for early repayments. In this case, Odin is taking longer to pay but still aiming to avoid overdue fees.
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