In an earlier blog (Financial Ratios – Profitability Ratios), I spoke about the importance of Profitability Ratios. In this blog, I highlight the importance of Efficiency Ratios.
In simple terms, Efficiency Ratios measure how well companies utilise their short term assets and short term liabilities to generate income. Efficiency ratios, for example, might include the time it takes for companies to collect cash from customers, how quickly or slowly they pay their suppliers and the time it takes to convert inventory into revenue.
While Efficiency Ratios are generally used by management to help improve the company, they are also often used to inform outside investors and creditors of the operational performance of the company.
Let’s consider a couple of examples of Efficiency Ratios:
Debtor Days tells you how many days it takes for the money to reach your bank account after you have issued invoices. The lower, the better. A decrease in the ratio is good; an increase should be regarded as an alarm bell.
Debtor Days = Debtors (Net of GST) / Annual Sales x 365
Creditor Days represents the average time that a business takes to pay its Creditors. The higher, the better.
Creditor Days = Creditors (Net of GST) / Annual Cost of Goods Sold x 365
If Debtor Days are smaller than Creditor Days, the customers pay the business quicker than the business pays its Suppliers, which is favourable as the business will need less funding (working capital requirement). In other words, the suppliers are financing part of the business.
If Debtor Days are higher than Creditor Days, the business is paying its suppliers quicker than it collects money from its customers. In that case, the business will either need to improve its collection, or will need to negotiate better payment conditions with suppliers, or will need more funding to finance its operations.
Inventory Days represents the average time a product stays in the warehouse or on the shelves of the store before it is sold to a client. The lower, the better.
Inventory Days = Inventory / Annual Cost of Goods Sold x 365.
When calculating these ratios at the end of a month or at the end of a quarter, you will need to calculate the last 12 months of Revenue and the last 12 months of Cost of Goods Sold. I strongly encourage monitoring these ratios monthly if possible, quarterly at the minimum.
I like to think in terms of “Days”, but some people prefer “Turnover” or how many times the Debtors, Creditors and Inventory turn per year.
Here are the calculations in terms of Turnover:
- Debtors Turnover ratio = Annual Revenue / Debtors
- Creditors Turnover ratio = Annual Cost of Goods Sold / Creditors
- Inventory Turnover ratio = Annual Cost of Goods Sold / Inventory
If you prefer thinking in terms of Turnover, the proportions have to be reversed: You will want a high Debtors Turnover, a low Creditors Turnover and a high Inventory Turnover.
As previously mentioned, it is important to monitor the trend for each of these ratios (going up, down or flat), investigate the reasons for a negative change and take corrective/improvement actions as required.
These ratios tend to vary from one industry sector to the next, so if you want to benchmark your business against others, it is important to compare the performance of your business with businesses in the same industry sector.