Table of Contents
Introduction
In addition to profitability and liquidity ratios, businesses also use efficiency and gearing ratios to evaluate their financial performance. Efficiency ratios measure how effectively a business manages its working capital, such as inventory, debtors, and creditors. Gearing ratios assess the extent to which a business relies on borrowed funds to finance its operations.
These ratios help managers, investors, and lenders understand how efficiently a business is operating and whether its level of debt is appropriate.
Stock Turnover Ratio
Meaning: The Stock Turnover Ratio measures how quickly a business sells and replaces its inventory during a given period. It indicates how efficiently inventory is being managed.
| Formula: Stock turnover (times) = Cost of goods sold ÷ Average inventoryAverage inventory = Opening inventory +Closing inventory ÷2 |
Debtor days ratio
Meaning: The Debtor Days Ratio measures the average number of days customers take to pay the business for goods or services purchased on credit.
| Formula: Debtor Days = (Trade Debtors ÷ Total sales revenue) × 365 |
Creditor days ratio
Meaning: The Creditor Days Ratio measures the average number of days a business takes to pay its suppliers.
| Formula: Creditor days = (Trade Creditors ÷ Cost of goods sold) × 365 |
Gearing Ratio
Meaning: The Gearing Ratio measures the proportion of a business’s capital that is financed through long-term debt compared with owner’s equity.
| Formula: Gearing ratio (%) = (Non-current liabilities ÷ Capital Employed) × 100 |
Interpretation
- A high gearing ratio indicates greater reliance on borrowed funds and higher financial risk.
- A low gearing ratio suggests lower financial risk and less dependence on debt financing.
Thus, efficiency ratios such as stock turnover, debtor days, and creditor days help assess how effectively a business manages its working capital. The gearing ratio measures the extent to which a business relies on long-term debt. Together, these ratios provide valuable insights into operational efficiency, cash flow management, and financial risk.
Quick Recap
1. Efficiency ratios measure how effectively a business manages its working capital, while gearing ratios measure the extent to which a business relies on long-term debt.
2. The Stock Turnover Ratio measures how quickly a business sells and replaces its inventory.
Formula: Cost of Goods Sold ÷ Average Inventory
3. Average Inventory is calculated as:
(Opening Inventory + Closing Inventory) ÷ 2
4. A high stock turnover ratio generally indicates efficient inventory management, while a low ratio may suggest slow-moving or excess inventory.
5. The Debtor Days Ratio measures the average number of days customers take to pay for credit sales.
Formula: (Trade Debtors ÷ Sales Revenue) × 365
6. A lower debtor days ratio improves cash flow because customers pay more quickly.
7. The Creditor Days Ratio measures the average number of days a business takes to pay its suppliers.
Formula: (Trade Creditors ÷ Cost of Goods Sold) × 365
8. The Gearing Ratio measures the proportion of long-term finance provided by debt.
Formula: (Non-current Liabilities ÷ Capital Employed) × 100
9. A high gearing ratio indicates greater dependence on borrowed funds and higher financial risk, whereas a low gearing ratio indicates lower financial risk.
10. Together, efficiency and gearing ratios help businesses evaluate inventory management, cash flow, operational efficiency, debt levels, and overall financial stability.
