3.6. Efficiency ratio analysis - HL only

Average inventory is used instead of ending inventory because many companies' merchandise fluctuates greatly throughout the year. For instance, a company might purchase a large quantity of merchandise January 1 and sell that for the rest of the year. By December almost the entire inventory is sold and the ending balance does not accurately reflect the company's actual inventory during the year. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two.

The cost of goods sold is reported on the income statement.

This ratio can also be calculated in terms of days. It is appropriate to use either closing stock or average stock.

Stock turnover days = Average Stock /cost of goods sold x 365

= 0.5m/2m x 365 = 91.25 days

Analysis

Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys.

This measurement also shows investors how liquid a company's inventory is. Think about it. Inventory is one of the biggest assets a retailer reports on its balance sheet. If this inventory can't be sold, it is worthless to the company. This measurement shows how easily a company can turn its inventory into cash.

Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks want to know that this inventory will be easy to sell.

Inventory turns vary with industry. For instance, the apparel industry will have higher turns than the exotic car industry.

Inventory with a high turnover is less likely to become obsolete. This also results in greater levels of liquidity as inventory is being converted into cash in a shorter time period. If the inventory turnover time increases corrective measures need to be taken.

Example

Donny's Furniture Company sells industrial furniture for office buildings. During the current year, Donny reported cost of goods sold on its income statement of $1,000,000. Donny's beginning inventory was $3,000,000 and its ending inventory was $4,000,000. Donny's turnover is calculated like this:

The reason net credit sales are used instead of net sales is that cash sales don't create receivables. Only credit sales establish a receivable, so the cash sales are left out of the calculation. Net sales simply refers to sales minus returns and refunded sales.

The net credit sales can usually be found on the company's income statement for the year although not all companies report cash and credit sales separately. Average receivables is calculated by adding the beginning and ending receivables for the year and dividing by two. In a sense, this is a rough calculation of the average receivables for the year.

This ratio can also be expressed in days

IB specified debtor days ratio

Analysis

Since the receivables turnover ratio measures a business' ability to efficiently collect its receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the company collected its average receivables twice during the year. In other words, this company is collecting is money from customers every six months.

Higher efficiency is favourable from a cash flow standpoint as well. If a company can collect cash from customers sooner, it will be able to use that cash to pay bills and other obligations sooner.

Accounts receivable turnover also is an indication of the quality of credit sales and receivables. A company with a higher ratio shows that credit sales are more likely to be collected than a company with a lower ratio. Since accounts receivable are often posted as collateral for loans, quality of receivables is important.

Example

Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to all of his main customers. At the end of the year, Bill's balance sheet shows $20,000 in accounts receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year's balance sheet showed $10,000 of accounts receivable.

The first thing we need to do in order to calculate Bill's turnover is to calculate net credit sales and average accounts receivable. Net credit sales equals gross credit sales minus returns (75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).

Finally, Bill's accounts receivable turnover ratio for the year can be like this.

The total purchases number is usually not readily available on any general purpose financial statement. Thus because of this, we use the Cost of Goods sold.

The average payables/creditors is used because accounts payable can vary throughout the year. The ending balance might be representative of the total year, so an average is used. To find the average accounts payable, simply add the beginning and ending accounts payable together and divide by two.

IB specified Creditor days ratio

Analysis

Since the accounts payable turnover ratio indicates how quickly a company pays off its vendors, it is used by supplies and creditors to help decide whether or not to grant credit to a business. As with most liquidity ratios, a higher ratio is almost always more favorable than a lower ratio.

A higher ratio shows suppliers and creditors that the company pays its bills frequently and regularly. It also implies that new vendors will get paid back quickly. A high turnover ratio can be used to negotiate favorable credit terms in the future. As with all ratios, the accounts payable turnover is specific to different industries. Every industry has a slightly different standard. This ratio is best used to compare similar companies in the same industry.

Example

Bob's Building Suppliers buys constructions equipment and materials from wholesalers and resells this inventory to the general public in its retail store. During the current year Bob purchased $1,000,000 worth of construction materials from his vendors. According to Bob's balance sheet, his beginning accounts payable was $55,000 and his ending accounts payable was $958,000.

Here is how Bob's vendors would calculate his payable turnover ratio:

Notes:

Long-term liabilities include loans due more than one year + preference shares + mortgages

Capital employed = Share capital + retained earnings + long-term liabilities

How can the gearing ratio be evaluated?

• A business with a gearing ratio of more than 50% is traditionally said to be "highly geared".
• A business with gearing of less than 25% is traditionally described as having "low gearing"
• Something between 25% - 50% would be considered normal for a well-established business which is happy to finance its activities using debt.

It is important to remember that financing a business through long-term debt is not necessarily a bad thing! Long-term debt is normally cheap, and it reduces the amount that shareholders have to invest in the business.

What is a sensible level of gearing? Much depends on the ability of the business to grow profits and generate positive cash flow to service the debt. A mature business which produces strong and reliable cash flows can handle a much higher level of gearing than a business where the cash flows are unpredictable and uncertain.

Another important point to remember is that the long-term capital structure of the business is very much in the control of the shareholders and management. Steps can be taken to change or manage the level of gearing – for example:

Task 1: The following information is available about Philox Ltd at 31 December 2013

Turnover for year (all credit sales) $240000

Purchases for year (on credit) $140000

Opening stock $90000

Closing stock $60000

Trade debtors at end of year $40000

Trade creditors at end of year $45000

Bank and cash balances $55000

Long-term loans at end of year $80000

Shareholders’ funds at end of year $155000

Fixed assets (net) at end of year $125000

(a) Calculate both gross profit and cost of goods sold

(b) Calculate the net current assets at the end of the year

(c) Prepare a summarized balance sheet at the end of the year

(d) Calculate stock turnover, credit days given (Debtor days) and credit days received (Creditor Days)

Task 2: Bradbury Ltd is a family-owned clothes manufacturer based in Hong Kong. For a number of years, the chairman and managing director of the company was David Bradbury. During his period of office, the company’s sales turnover had grown steadily at a rate of 2-3% each year. David Bradbury retired on 31 December 2012 and was succeeded by his daughter Simone. Soon after taking office Simone decided to expand the business. Within weeks she had successfully negotiated a five-year contract with a large clothes retailer to make a range of sports and leisurewear items. The contract will result in additional $2 million sales during each year of the contract. In order to fulfil the contract, new equipment and premises were acquired by Bradbury Ltd.

Financial information concerning the company is given below:

Partial Profit & Loss Accounts

Balance sheets/statement of financial position