Chapter 34, Analysis of Published Accounts
Learning Objective: To understand Financial Efficiency Ratios
Although we have been learning some important measures of performance and liquidity, there are other ratios that businesses should keep in mind, they are called Financial Efficiency Ratios - they are concerned with the efficiency to which the business uses its financial resources.
Financial efficiency is important as it measures how efficiently managers are utilizing the business' assets and therefore minimizing the need of borrowing (liabilities).
We will be looking into three Financial Efficiency Ratios:
Inventory Turnover;
Trade Receivables Turnover;
Trade Payables Turnover.
1) Inventory Turnover: usually, the less finance attached to inventory the better for a business:
The rate of inventory turnover records the number of times the inventory of a business is bought in and resold in a period of time. The higher this number, the lower the amount of finance used to hold inventories. On the other hand, if the business bought in inventory just once each year (sufficient for the whole year), it is considered financially inefficient.
The formulas used, in this case, are:
The result is not a percentage but a ratio of how many times inventory turns over in a given period of time;
Companies implementing JIT would have a high ratio of inventory turnover;
Results depend on the industry (e.g. fresh fish retailer vs. car dealer) and therefore comparisons should be intra-industry;
Service sector businesses find this metric to be irrelevant.
2) Trade Receivables Turnover (days): measures how long (on average) businesses take to recover payments on credit (trade receivables):
The shorter, the better as it indicates better control over working capital.
Results depend on the industry competitiveness and pressure for longer credit terms;
Results can indicate poor management of repayment periods;
Results can be a strategy from management to attract customers;
Results can be improved by reducing credit terms - there can be a negative impact on sales.
3) Trade Payables Turnover (days): measures how long the business takes to pay its suppliers:
The higher, the lower the working capital needs of the business will be - which is good.
- If this number is lower than the Trade Receivables Turnover there will be a cash-flow problem: greater need for working capital, lower financial efficiency;
- The formula can use either credit purchases or CoS:
How can businesses improve financial efficiency?
Better manage inventories (e.g. JIT) to increase inventory turnover:
Risk of factory disruptions, potentially higher delivery (frequent) costs, reduction in bulk buying discounts. There needs to be a great relationship with a reliable supplier for it to work.
Reduce credit offered to customers:
Delay payments to suppliers:
To-Do List: Activity 34.4
Chapter 34 - Analysis of Published Accounts
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