It is time for the next in the ratio analysis series – efficiency ratios!
So if you have been following the ratio analysis series, you will remember that we first discussed profitability ratios, to measure how profitable the business is. Then we looked at gearing/liquidity ratios which helps us determine whether or not the business has too much debt. Today we’ll cap it all off by looking at efficiency ratios.
Efficiency ratios, as the name suggests, looks at how efficient the business process is. This efficiency tends to be measured in terms of days. Efficiency ratios are also used to calculate the working capital cycle – which I’ve written about before over here. In a way, you can say that this article is an extension of the discussion we had about the working capital cycle previously.
With that, let’s look at the first efficiency ratio:
Inventory Turnover Ratio
The inventory turnover ratio measures how quickly your business sells off stock. Now if you are a service business – move along, nothing to see here since inventory is only relevant to businesses that deal with inventory (like retail, manufacturing and food).
The inventory turnover ratio is a great indicator of how well your stock is selling by the end of the year. You can take the inventory turnover ratio and multiply it by 365 days in a year to get an estimate of how long it takes (on average) for a piece of inventory to get sold after purchasing it!
Inventory days is a really great way to estimate how long you are holding inventory for. Obviously, the shorter the time you hold inventory, the better it is for your business since your stocks are flying off the shelves! That being said, different industries have different lengths of time for inventory days. A business selling yachts will have a much longer Inventory day as compared to a business selling groceries.
Debtor Ratio
Not to be confused with any of the debt ratios, the DEBTOR ratio (or known in accounting-ese as ‘Accounts Receivable’) looks at the proportion of your debtor balance at to your sales in a year. In a nutshell, it shows you the ratio of sales still owing to the sales made in the year.
Much like the inventory turnover ratio, the debtor ratio can be multiplied by 365 days in a year to get debtor days to get an estimate of how long it takes (on average) to collect your debts from your customers!
The faster you collect your debts, the better! This is the general advice I would give to all businesses! There isn’t a business in the world that would want their debtors to take their own sweet time in paying up!
Armed with the knowledge from debtor days, you can start thinking about ways to keep your debtor days low and start chasing down those people who owe you money!!
Creditor Ratio
On the opposite side of things, we have the creditor ratio (Accounts payable in accounting-ese). The creditor ratio looks at the amount of money YOU owe other people, compared against the total amount of purchases you have made. When I say ‘Purchases’ I mean direct costs which relate to the production of your goods/services. We are NOT looking at overheads or other general expenses.
Much like the debtor ratio, the creditor ratio shows you the ratio of stuff you still owe VS the stuff you already paid for, but for purchases, instead of sales. Much like the debtor ratio as well, you can multiply the creditor ratio with 365 days in a year to get your Creditor Days:
Creditor days is another useful little number which tells you, on average how long it takes for your business to pay off their creditors. Generally speaking, the longer you take to pay your creditors… the better… buuuuuutttt from an ethical point of view, you can’t expect YOUR customers to hurry up in paying you if you can’t do the same for your creditors now can you?
BONUS: Working Capital Cycle!!
Now you have gotten your inventory days, debtor days and creditor days. Yay! What do you do? You calculate your working capital cycle!
A few weeks ago I wrote about working capital cycle management as part of what businesses needed to do to manage their cash flow in the COVID-19 crisis. If you haven’t read it – go on and click that link to check it out.
To briefly re-cap – the working capital cycle is the length of time it takes to convert sales into cold, hard cash! It gives you, the business owner, a VERY useful estimate of how long the business will need to be financed for.
To calculate the the working capital cycle is super easy:
So as you can see, we calculate all those days together and what we have is our working capital cycle in days. These show how many days the business needs to survive on their cash reserves before new cash comes in. From a practical perspective you will then need to estimate how much cash you would be spending in those days and plan accordingly!
Let’s take an example:
Willard’s Shoes (It’s a business! Not actual shoes!) has inventory days of 30, debtor days of 10 and creditor days of 20. Using the working capital cycle formula, they work out their working capital cycle to be 20 days (30+10-20). Willard works out that the business’ monthly expenses are about $12,000 – which means that 20 days worth of expenses are roughly $8,000 (20/30 X 12,000). This means that Willard needs to make sure that his business has at least $8,000 worth of cash reserves on hand. If they don’t have enough, then Willard needs to find a way to raise that $8,000 either through a bank loan or getting some equity into the business.
The working capital cycle is a VERY useful tool for planning ahead and managing your cash flow. Use it well and use it wisely! Here’s a simple diagram for a refresher:
So that’s all we have for ratio analysis. I will admit that it is a bit heavier than my usual fare – but if you are keen on enhancing your business processes, ratio analysis is a really great way of calculating how well your business is doing and determining what more can be done to enhance it!
Trying times lay ahead for all of us as we head into a Global Recession. As business owners, we need to do all we can to stay ahead, stay educated and most of all:
Stay positive!