Accounting (Year 12) - Ratios
What are Efficiency Ratios?
Efficiency ratios measure the ability for a company to use its resources (often its people and machinery) to make money.
Basically it measures how much money a company spends to make a dollar in revenue.
Inventory turnover ratio measures the amount of times a company has sold and restocked inventory. For example, consider a store that sells milk, if an inventory turnover for the year is 5, this means on average, the company has sold and replaced its inventory of milk five times.
The inventory turnover is calculated as total cost of sales over average inventory. Average inventory is calculated as the average between the opening balance and the closing balance of Inventory.
In other words, (opening bal of inventory + closing bal of inventory) / 2.
High Number: Favourable, as it means the business is selling and replacing more of its inventory, which results in more money.
Low Number: Unfavourable, as it means the business is selling and replacing less inventory which results in less money. The numbers are all relative to the industry average. Think about a common product, such as a fast-food restaurant selling fries. A turnover of 365 times per year may sound good, but this means it only sells one packet of fries per day.
Debtors Collection Period
Imagine if you were running a business, you would want your customers to pay you as soon as possible. The debtors collection period measures on average the amount of time it takes to collect debtors. For example, if the debtors collection period is 20, it means on average it takes 20 days to collect debts.
To calculate the Debtors Collection Period, calculate the average debtors over net credit sales, multiplied by 365 days. Average debtors is calculated as the average between the opening balance and the closing balance of debtors. In other words, (opening bal of Accounts Rec + closing bal of Accounts Rec) / 2.
High Number: Unfavourable, this means it takes longer to recover debts. This results in poor control of cash flow and potential bad debts.
Low Number: Favourable, this means it takes a short amount of time to recover debts. This results in a good control of cash flow and reduces the risk of bad debts.