Efficiency ratios

We discussed the importance of financial ratios along with their limitations for financial analysis purposes. After having described profitability ratios we can have an insight on efficiency ratios. This kind of ratios aims at measuring how successfully the resources of business are managed.

The most important ratios within this category are:

Average inventories turnover period

For many organisations, inventories are an essential part of their business and may account a substantial part of the assets held. This ratio measures the average time (in days, weeks or months) for which inventories are held:

AITP = (Average inventories held / Cost of sales) x 365 

Average inventories can be calculated as the average of opening and closing inventories for the period. In case of highly seasonal business, a monthly or weekly basis instead of a yearly one would be preferable.

A business normally prefers a short inventories turnover period.

Average settlement period for trade receivables

A business which sells on credit will be concerned about the amount of funds tied up in trade receivables and the will always try to keep this time at minimum. Speed of payments can deeply affect the organisation’s cash flow. This ratio measures how long on average credit customers take to pay the amounts due to the business.

ASPTR = (Average trade receivables / Credit sales revenue) x 365

A business would normally prefer a short average settlement period. On the other hand, this ratio is an average and could hinder the situation of clients whose payments are outstanding.

Average settlement period for trade payables

This ratio measures how long on average the business takes to pay those who provided goods/services on credit:

ASPTP = (Average trade payables / Credit purchases) x 365

Similarly to the previous ratio, we should consider that this is an average value and may hinder some outstanding situations. Trade payables are undoubtedly a form of finance for the business, therefore we might want it to be as higher as possible. On the other hand, we should manage it in order not to result in a loss of goodwill of suppliers.

Sales revenue to capital employed

This ratio measures how effectively the assets of the business are employed in the attempt of producing revenue.

SRCE = Sales revenue / Share capital + Reserves + Non-current liabilities

Generally, a higher SRCE is preferred to a lower one because a higher ratio suggests that assets are used efficiently in the process of profit creation. However a too high ratio may suggest that the company is overtrading on its assets and therefore there are insufficient assets to sustain the level of sales.

Sales revenue for employees

Sales are related to one input resource which is labour. This ratio can be considered a measure of productivity:

SRE = Sales revenue / Number of employees

A higher value for this ratio suggests that a good productivity level has been achieved.

 

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