Efficiency Ratios (Cambridge International AS 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:
- Non-current asset turnover
- Rate of inventory turnover
- Inventory turnover
- Trade receivables turnover
- Trade payables turnover
Non-current asset turnover
Spec point — how to calculate key accounting ratios to measure efficiency: – efficiency ratios: non-current asset turnover, trade receivables turnover (days), trade payables turnover (days), inventory turnover (days), rate of inventory turnover (times)
Non-current asset turnover
What is the non-current asset 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 how many times bigger the net revenue is compared to the net book value of the non-current assets |
| How can the ratio be improved? | - Increase the volume of sales - Sell or dispose of unused non-current assets - Buy more efficient non-current assets |
- This ratio quantities how effectively a business is using its non-current assets to generate revenue
Worked Example Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.
$ Sales 40 000 Non-current assets at cost 50 000 Accumulated depreciation of non-current assets 18 000 Calculate the non-current asset turnover for the year ended 29 February 2024. The calculation should be correct to two decimal places.
Answer:
- Calculate the bet book value of the non-current assets
$50 000 - $18 000 = $32 000
Calculate the non-current asset turnover
- Round to two decimal places
Final answer: Non-current asset turnover = 1.56 times
Rate of inventory turnover
Spec point — how to calculate key accounting ratios to measure efficiency: – efficiency ratios: non-current asset turnover, trade receivables turnover (days), trade payables turnover (days), inventory turnover (days), rate of inventory turnover (times)
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
Inventory turnover
Spec point — how to calculate key accounting ratios to measure efficiency: – efficiency ratios: non-current asset turnover, trade receivables turnover (days), trade payables turnover (days), inventory turnover (days), rate of inventory turnover (times)
Inventory turnover
What is the inventory 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 sell its inventory |
| 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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This is just another way of measuring the rate of inventory turnover
- This ratio calculates the average number of days taken to sell the inventory
- Rather than the number of times it sells its inventory in a year
Exam Hint You can easily convert between the inventory turnover and the rate of inventory turnover.
Just divide 365 by one ratio to calculate the other one.
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 inventory turnover for the year ended 29 February 2024. Round up your answer to the next whole day.
Answer:
Calculate the average inventory
\frac{\ 7 000 + $ 9 000}{2} = $ 8 000$
Calculate the cost of sales
- Opening inventory + Purchases - Closing inventory
$7 000 + $25 000 - $9 000 = $23 000
Calculate the inventory turnover
- Round up to the next whole day
Final answer: Inventory turnover = 127 days
Trade receivables turnover
Spec point — how to calculate key accounting ratios to measure efficiency: – efficiency ratios: non-current asset turnover, trade receivables turnover (days), trade payables turnover (days), inventory turnover (days), rate of inventory turnover (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 — how to calculate key accounting ratios to measure efficiency: – efficiency ratios: non-current asset turnover, trade receivables turnover (days), trade payables turnover (days), inventory turnover (days), rate of inventory turnover (times)
Trade payables turnover
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
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