Efficiency Ratios: Stock Turnover & Gearing Ratio (HL IB Business Management)

• Efficiency ratios show how well a business utilises its assets and liabilities to generate sales and maximise profits 
• They can provide insights into the operational efficiency of a business, including
  • How well stocks are being managed
  • The time taken for a business to settle debts with its creditors
  • How well credit offered to customers is being controlled
  • The balance of business funding between loans and equity capital
     
• Stakeholders, such as investors, can use the ratios to assess how well a company manages its resources
• Management can use ratios to set targets for key staff
   

Diagram: The four main Efficiency Ratios

Efficiency ratios provide insights into the operational efficiency of a business

• The stock turnover ratio shows how well a business converts its stock into sales
  
• Before calculating stock turnover it is first necessary to calculate the average value of stock held by a business in a given period
  • It is calculated using the formula

Calculating the Stock Turnover Ratio

• Stock turnover can then be calculated in two ways

1. Number of times a business sells all of its stock during a period (usually a year)

• • Businesses aim for a high or increasing ratio

• • • More stock sold means that it is generating profit more efficiently
    • Perishable goods are less likely to be wasted
      
      

2. Number of days taken to sell all of its stock
 

• • Businesses aim for a low or falling ratio
  • Selling stock quickly means profit is achieved swiftly
  • Less likely to hold obsolete stock that may need to be sold at a loss

Ways to Improve the Stock Turnover Ratio

• The stock turnover ratio can be improved by holding less stock or reducing cost of sales
   

Improving the Stock Turnover Ratio

Stock Turnover Variations

• There is no ideal ratio for stock turnover
  • Some businesses will have a very low stock turnover ratio as they sell few products - usually at a high price
    • Examples include 
      • Jewellers
      • Luxury vehicles
      • Specialist equipment or services
        
        
  • Other businesses have a very high stock turnover ratio
    • Their business model often requires this - for example, they may sell perishable goods
      • Examples include
        • Supermarkets
        • Florists
        • Takeaway food businesses

• The gearing ratio illustrates the long-term financial structure of the business
  • It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used to fund a business
  • The outcome is expressed as a percentage and is calculated with the following formula
    
    

• • Capital employed can be calculated by adding non-current (long term) liabilities to the equity
     

Interpreting the results 

• If the outcome is less than 50% the business is low-geared
  • The business is largely funded by shareholder capital
    
    
• If the outcome is more than 50% the business is highly-geared
  • The business is largely funded by loan capital

Problems Associated with High Gearing

• The higher the gearing ratio the more dependent a business is on long-term borrowing
• High gearing can be problematic for several reasons
   

Risks Associated with High Gearing 

Situations Where High Gearing is Less Problematic

• When interest rates are low - and expected to remain low 
  • Interest rates in Europe have been historically low for more than a decade
  • Many businesses have taken advantage of borrowing cheaply to fund investment
    
    
•  Large and profitable businesses are capable of meeting debt obligations
  • Multinational car manufacturers such as Toyota and Volkswagen are highly geared
  • High levels of borrowing have funded research into new generations of electric vehicles
     

Ways to Improve Gearing

• Improving gearing usually means lowering it
• This can be achieved by reducing long-term borrowing or raising more equity capital
   

Ways to Improve Gearing