Efficiency Ratio Analysis HL Only
Analysing how efficiently a business manages its stock, debtors, creditors, and capital structure.
All content on this page is Higher Level only. SL students are not assessed on these ratios.
- Calculate stock turnover (times and days), debtor days, and creditor days
- Calculate the gearing ratio and interpret the level of financial risk
- Explain the relationship between debtor days and creditor days and its effect on working capital
- Distinguish between insolvency and bankruptcy
Efficiency Ratios
Efficiency ratios (also called activity ratios) measure how well a business manages its working capital components — stock, debtors, and creditors — and how its capital is structured.
1. Stock Turnover
How many times a business sells through its average stock in a year. Can also be expressed in days (how long stock sits before being sold).
Average Stock = (Opening Stock + Closing Stock) ÷ 2
Note: "Cost of sales" is sometimes called cost of goods sold (COGS).
Interpretation: Higher turnover (fewer days) = stock sold quickly = efficient. Lower turnover = slow-moving stock = cash tied up, risk of obsolescence. Context matters: a supermarket turns over stock in days; a jeweller in months.
Benchmarks (rough — context varies widely): Below 30 days is efficient with low obsolescence risk. Above 90 days may signal excess inventory, high storage costs, or slow sales. Sectors like aerospace or jewellery naturally have longer stock days — compare within industry.
2. Debtor Days (Debtor Collection Period)
How many days on average it takes the business to collect payment from its customers (debtors).
Interpretation: Fewer days = cash collected faster = better liquidity. If debtor days are increasing, customers are taking longer to pay — a warning sign. Compare to the credit terms offered (e.g. if you offer 30 days but collect in 55, there's a problem).
Benchmarks (rough): Below 30 days indicates efficient credit control. Above 90 days suggests poor cash flow management and rising bad debt risk.
3. Creditor Days (Creditor Payment Period)
How many days on average the business takes to pay its suppliers (creditors).
Interpretation: More days = business holds cash longer before paying = better short-term cash position. But paying too slowly damages supplier relationships and creditworthiness. Compare to supplier credit terms.
Benchmarks (rough): Above 60 days is favourable for cash flow, provided it does not strain supplier relationships. Below 30 days may mean the business is paying unnecessarily quickly, hurting its own liquidity.
The ideal position: collect from debtors quickly, pay creditors slowly, and turn over stock fast. This maximises the cash available in the business at any time.
4. Gearing Ratio
Measures the proportion of a business's capital that is financed by long-term debt (loan capital) versus equity.
Capital Employed = Non-current liabilities + Equity (shareholders' funds)
Interpretation:
- High gearing (>50%): Most finance is from debt. Higher financial risk — interest must be paid even in bad years. Vulnerable if interest rates rise.
- Low gearing (<25%): Mostly equity-financed. Less risk but equity is often more expensive and dilutes ownership.
- ~50%: Often considered a reasonable balance.
| High Gearing | Low Gearing | |
|---|---|---|
| Financial risk | Higher (must service debt) | Lower |
| Control | Owners retain more control | More shareholders = diluted control |
| Interest rates | Very exposed to rate rises | Less exposed |
| In a recession | Dangerous — debt must still be paid | More resilient |
| Common in | Capital-intensive industries (property, utilities) | Service businesses, tech |
Strategies to Improve Efficiency Ratios
| Ratio | To improve… | Action |
|---|---|---|
| Stock turnover | Sell stock faster | Promotions, better demand forecasting, reduce stock levels, lean production |
| Debtor days | Collect cash faster | Tighter credit terms, early payment discounts, debt factoring |
| Creditor days | Hold cash longer | Negotiate longer payment terms with suppliers |
| Gearing | Reduce debt reliance | Issue more shares, repay loans using retained profit |
Insolvency vs Bankruptcy
A profitable business can become insolvent if it runs out of cash (poor liquidity). This is the key distinction between profitability and liquidity — a business can be profitable on paper but still fail due to cash flow problems.
Key Terms
- Stock turnover = Cost of sales ÷ Average stock (higher = more efficient)
- Debtor days = (Debtors ÷ Total sales revenue) × 365 (lower = cash faster)
- Creditor days = (Creditors ÷ Cost of sales) × 365 (higher = cash held longer)
- Gearing = (Non-current liabilities ÷ Capital employed) × 100
- High gearing = more financial risk; low gearing = less risk but diluted control
- Insolvency = can't pay debts; bankruptcy = the legal process that may follow
COGS: $600,000 | Opening stock: $80,000 | Closing stock: $100,000
Calculate (a) stock turnover (times) and (b) stock days. Comment on the result. [5 marks]
Show answer
Average stock = ($80,000 + $100,000) ÷ 2 = $90,000
(a) Stock turnover = $600,000 ÷ $90,000 = 6.67 times
(b) Stock days = ($90,000 ÷ $600,000) × 365 = 54.75 days ≈ 55 days
The business turns over its stock roughly every 55 days. Whether this is acceptable depends on the industry — for fresh food this would be poor; for a furniture retailer it may be normal.
Common mistake: Using closing stock alone instead of average stock. Average stock = (opening stock + closing stock) ÷ 2. Using only one figure gives a distorted picture, especially for seasonal businesses.
Calculate debtor days and creditor days. What does the comparison suggest? [6 marks]
Show answer
Debtor days = ($120,000 ÷ $1,200,000) × 365 = 36.5 days
Creditor days = ($80,000 ÷ $700,000) × 365 = 41.7 days
The business pays its suppliers in ~42 days but collects from customers in ~37 days — a positive working capital cycle. The business receives cash before it needs to pay suppliers, which supports liquidity. However, if credit terms offered to customers are 30 days, debtor days of 37 suggests some late payments.
Common mistake: Using revenue for creditor days instead of cost of sales (or purchases). Creditors relate to what you buy, not what you sell. Similarly, debtor days uses total sales revenue, not cost of sales. Using the wrong figure for either will give an incorrect result.
Show answer
Capital employed = $4,000,000 + $6,000,000 = $10,000,000
Gearing = ($4,000,000 ÷ $10,000,000) × 100 = 40%
At 40%, the company is moderately geared — below the 50% threshold often considered high risk. It has more equity than debt in its capital structure, suggesting manageable financial risk. However, in a high interest-rate environment, the $4m in debt would still generate significant interest charges.
Common mistake: Putting non-current liabilities over equity (instead of over capital employed). Gearing = non-current liabilities ÷ capital employed × 100, where capital employed = non-current liabilities + equity. Dividing by equity alone always gives a much higher (and incorrect) figure.