Efficiency Analysis

This is similar to liquidity analysis in that it assess current assets and liabilities. The purpose of efficiency analysis, however, is to identify how effectively/efficiently management uses its resources (or working capital) to run the business.

Inventory turnover period

This is calculated as:

Inventory / cost of sales x 365

This simply measures how efficiently management uses its inventory to produce and sell goods.

An increasing number of days implies that management are holding onto inventory for longer. This could indicate lack of demand or poor inventory control.

Alternatively, the increase in inventory holding could be due to:

• buying bulk to take advantage of trade discounts
• reducing the risk of "stockouts," or
• an expected increase in orders.

Either way, the consequence is that the costs of storing, handling and insuring inventory levels will also increase. There is also an increased risk of inventory damage and obsolescence.

Alternative

An alternative is to express the inventory turnover period as a number of times:

Cost of sales / inventory = times p.a. the average inventory is consumed

A high turnover indicates that management generally hold quite a low level of inventory in comparison to overall sales. This means their costs of holding inventory are reduced, although they may need more frequent deliveries. A just in time system would reflect this sort of strategy. A low inventory turnover indicates that management hold on to a high level of inventory in comparison to overall sales levels.

A word of caution

Year-end inventory is normally used in the calculation of inventory turnover. An average (based on the average of year-start and year-end inventories) may be used to have a smoothing effect, although this may dampen the effect of a major change in the period.

Inventory turnover ratios vary enormously with the nature of the business. For example, a fishmonger selling fresh fish would have an inventory turnover period of 1–2 days, whereas a building contractor may have an inventory turnover period of 200 days. Manufacturing companies may have an inventory turnover ratio of 60–100 days; this period is likely to increase as the goods made become larger and more complex.

For large and complex items (e.g. rolling stock or aircraft) there may be sharp fluctuations in inventory turnover according to whether delivery took place just before or just after the year end.

A manufacturer should take into consideration:

• reliability of suppliers: if the supplier is unreliable it is prudent to hold more raw materials
• demand: if demand is erratic it is prudent to hold more finished goods.

Receivables collection period

This is normally expressed as a number of days:

Trade receivables / credit sales x 365

The ratio shows, on average, how long it takes to collect cash from credit customers once they have purchased goods. The collection period should be compared with:

• the stated credit policy
• previous period figures.

Increasing accounts receivables collection period is usually a bad sign suggesting lack of proper credit control which may lead to irrecoverable debts.

It may, however, be due to:

• a deliberate policy to attract more trade, or
• a major new customer being allowed different terms.

Falling receivables days is usually a good sign, though it could indicate that the company is suffering a cash shortage.

The trade receivables used may be a year-end figure or the average for the year. Where an average is used to calculate the number of days, the ratio is the average number of days' credit taken by customers.

For many businesses total sales revenue can safely be used, because cash sales will be insignificant. But cash-based businesses like supermarkets make the substantial majority of their sales for cash, so the receivables period should be calculated by reference to credit sales only.

The result should be compared with the stated credit policy. A period of 30 days or 'at the end of the month following delivery' are common credit terms.

The receivables days ratio can be distorted by:

• using year-end figures which do not represent average receivables
• factoring of accounts receivables which results in very low trade receivables
• sales on unusually long credit terms to some customers.

Payables payment period

This is usually expressed as:

Trade payables / credit purchases x 365

This represents the credit period taken by the company from its suppliers.

The ratio is always compared to previous years:

• A long credit period may be good as it represents a source of free finance.
• A long credit period may indicate that the company is unable to pay more quickly because of liquidity problems.

If the credit period is long:

• the company may develop a poor reputation as a slow payer and may not be able to find new suppliers
• existing suppliers may decide to discontinue supplies
• the company may be losing out on worthwhile cash discounts.

In most sets of basic financial statements the figure for purchases will not be available therefore cost of sales is normally used as an approximation in the calculation of the accounts payable payment period.

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