3.6 Efficiency ratio analysis

Efficiency ratios show how effectively a business manages stock, customer credit, supplier credit and long-term finance. Debtor days = debtors ÷ credit sales × 365; creditor days = creditors ÷ cost of sales × 365; stock turnover compares cost of sales with average stock; gearing compares non-current liabilities with capital employed.

Lower debtor days usually means faster collection; higher creditor days can preserve cash but may damage supplier trust. A high stock-turnover rate can indicate efficient sales, while high gearing increases financial risk and interest exposure.

With debtors of €31,200 and credit sales of €241,200, debtor days are about 47.23. Interpret the number against agreed terms, product cycle and industry rather than treating a single benchmark as universally good.

Every efficiency ratio has a trade-off and a denominator that matters. Never compare ratios across unrelated sectors without checking business model, seasonality and accounting definitions.

Use complete, consistent formulas: average stock $=(\text{opening stock}+\text{closing stock})/2$; stock turnover $=\text{cost of sales}/\text{average stock}$, reported as times per year; debtor days $=\text{trade receivables}/\text{credit sales}\times365$; creditor days $=\text{trade payables}/\text{credit purchases}\times365$ (cost of sales may be used only when the course data require that convention); gearing $=\text{non-current liabilities}/\text{capital employed}\times100$. State the convention used and do not mix annual and partial-period figures.

Efficiency improves when a business converts stock into sales, collects receivables or uses capital with less waste and risk. The action should target the ratio’s mechanism, not simply make the number larger or smaller.

Faster invoicing and credit checks can reduce debtor days; better stock forecasting and smaller, more frequent orders can improve stock turnover; negotiated supplier terms can raise creditor days. Each choice changes relationships, service, cost or resilience.

A retailer may clear slow stock and automate reminders, but discounting too heavily can reduce margin and pressuring a key supplier can lose trade credit. Lower gearing may reduce risk while also limiting funds for productive expansion.

A ‘better’ ratio is context-dependent: high creditor days may be late payment, and fast stock turnover may reflect stockouts. Check the target, side effects and cash-flow evidence before recommending a change.

A business is insolvent when it cannot meet debts as they fall due or its liabilities exceed the value of its assets. Bankruptcy is a legal process for an unincorporated owner; a company may instead enter administration or liquidation.

A profitable business can become cash-flow insolvent if money is tied up in stock or receivables, while a temporary loss does not necessarily mean failure if finance remains available. The ownership form changes the legal consequences and who bears the loss.

If suppliers demand payment before a seasonal customer pays, a cash-flow forecast may reveal an immediate gap. Negotiating terms, raising finance or selling assets may help; if recovery fails, administration can protect a company while a plan is attempted, whereas liquidation sells assets and closes it.

Insolvency is not identical to bankruptcy, and one bad ratio does not prove either. Test whether debts can be paid when due and whether liabilities exceed assets, then identify the ownership form and applicable legal process before drawing a conclusion.