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

An Introduction to Efficiency Ratios

• 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

Stock Turnover

• 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

      Example include:

      • Supermarkets

      • Florists

      • Takeaway food businesses

Gearing Ratio

• 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