methods of improving financial efficiency

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10.2 Analysis of Published Accounts – Financial Efficiency Ratios

Learning Objective

To be able to define, calculate, interpret and critically evaluate the efficiency ratios required by the Cambridge 9609 syllabus, to link each ratio to a specific business decision and to suggest realistic methods for improving financial efficiency.

1. Efficiency Ratios (required by the syllabus)

Ratio Formula What it measures Typical interpretation Link to business decision
Inventory Turnover \(\displaystyle \text{Inventory Turnover}= \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}\) How many times inventory is sold and replaced in a period. Higher = efficient stock control; excessively high may cause stock‑outs. High turnover → consider JIT or tighter production scheduling; low turnover → review purchasing policy or discount slow‑moving stock.
Days Inventory Outstanding (DIO) \(\displaystyle \text{DIO}= \frac{365}{\text{Inventory Turnover}}\) Average number of days inventory is held before sale. Lower = faster conversion of stock to cash. Long DIO → look at reducing safety stock or improving demand forecasting.
Trade Receivables Turnover \(\displaystyle \text{Receivables Turnover}= \frac{\text{Net Credit Sales}}{\text{Average Trade Receivables}}\) How quickly credit sales are collected. Higher = faster cash collection. Low turnover → tighten credit policy or introduce early‑payment discounts.
Days Sales Outstanding (DSO) \(\displaystyle \text{DSO}= \frac{365}{\text{Receivables Turnover}}\) Average days taken to collect receivables. Lower = better credit control. Rising DSO → review customer credit limits and improve invoicing efficiency.
Payables Turnover \(\displaystyle \text{Payables Turnover}= \frac{\text{Purchases (or COGS)}}{\text{Average Trade Payables}}\) How quickly the business pays its suppliers. Lower turnover (higher DPO) retains cash longer but may affect supplier goodwill. Very low turnover → negotiate longer payment terms or staggered payments.
Days Payables Outstanding (DPO) \(\displaystyle \text{DPO}= \frac{365}{\text{Payables Turnover}}\) Average days taken to settle payables. Higher = cash retained longer, improving liquidity. Too high DPO → risk of strained supplier relationships; consider balancing with discounts for early payment.
Cash Conversion Cycle (CCC) \(\displaystyle \text{CCC}= \text{DIO} + \text{DSO} - \text{DPO}\) Overall time taken to convert resources into cash. Shorter cycle = greater operational efficiency and cash flow. Long CCC relative to industry → implement a combination of inventory, receivables and payables improvements.

2. Limitations of Ratio Analysis (Critical Evaluation)

  • Historical data – Ratios are based on past figures and may not reflect future conditions.
  • Different accounting policies – Variations in inventory valuation (FIFO vs. LIFO) or depreciation affect comparability.
  • Industry differences – “Good” values differ between sectors; always benchmark against appropriate peers.
  • Seasonality – Annual ratios can mask seasonal peaks and troughs; a seasonal adjustment or quarterly analysis may be required.
  • Window‑dressing – Companies may manipulate timing (e.g., delaying expense recognition or accelerating year‑end sales) to improve ratios temporarily.
  • Quantitative focus – Ratios ignore qualitative factors such as brand reputation, management quality, or market trends.

3. Methods of Improving Financial Efficiency

  1. Optimise inventory management
    • Adopt Just‑In‑Time (JIT) ordering or lean stock policies – reduces average inventory and DIO.
    • Use demand forecasting, safety‑stock analysis and ABC classification.
    • Limitation: JIT increases vulnerability to supply‑chain disruptions.
  2. Strengthen credit control
    • Set clear credit terms, perform credit checks and review payment histories.
    • Offer early‑payment discounts (e.g., 2 % if paid within 10 days).
    • Implement automated invoicing and reminder systems to lower DSO.
    • Limitation: Tight credit terms may deter new customers or reduce sales volume.
  3. Negotiate better supplier terms
    • Seek longer payment periods, staggered payments or early‑payment discounts.
    • Consolidate purchases for volume discounts.
    • Develop strategic partnerships that allow flexible cash‑flow arrangements.
    • Limitation: Extending DPO excessively can strain supplier relationships and affect supply reliability.
  4. Improve cash‑management practices
    • Prepare rolling cash‑flow forecasts to anticipate shortfalls.
    • Invest surplus cash in short‑term, low‑risk instruments (e.g., Treasury bills).
    • Use lock‑box services or electronic payments to accelerate receipt of funds.
    • Limitation: Short‑term investments often yield low returns and may expose cash to market volatility.
  5. Review pricing and product mix
    • Analyse contribution margins and focus on high‑margin products.
    • Adjust pricing to reflect inventory‑holding costs and credit risk.
    • Introduce bundled offers that encourage quicker turnover.
    • Limitation: Price changes can affect market positioning and may trigger price wars.
  6. Adopt technology solutions
    • Enterprise Resource Planning (ERP) systems integrate inventory, sales and finance data for real‑time monitoring.
    • Automated analytics dashboards provide instant ratio updates and alerts.
    • Electronic Data Interchange (EDI) speeds up the order‑to‑cash cycle.
    • Limitation: High upfront cost and staff training requirements; benefits realised only after full implementation.

4. Sample Calculation (Illustrative)

Data for XYZ Ltd (year ended 31 December)

  • Cost of Goods Sold (COGS): $500,000
  • Average Inventory: $50,000
  • Net Credit Sales: $600,000
  • Average Trade Receivables: $40,000
  • Average Trade Payables: $30,000
  • Current Assets: $120,000; Current Liabilities: $80,000
  • Gross Profit: $200,000; Net Profit: $80,000
  • Total Debt: $150,000; Equity: $250,000
  • Operating Profit (used for ROCE): $80,000
  • Total Assets: $400,000 (assumed)
RatioCalculationResult
Inventory Turnover \(500,000 \div 50,000\) 10 times
DIO \(365 \div 10\) 36.5 days
Receivables Turnover \(600,000 \div 40,000\) 15 times
DSO \(365 \div 15\) 24.3 days
Payables Turnover \(500,000 \div 30,000\) 16.7 times
DPO \(365 \div 16.7\) 21.9 days
Cash Conversion Cycle (CCC) \(36.5 + 24.3 - 21.9\) 38.9 days
Current Ratio \(120,000 \div 80,000\) 1.5 : 1
Quick Ratio \((120,000 - 50,000) \div 80,000\) 0.88 : 1
Gross Profit Margin \((200,000 \div 600,000) \times 100\) 33.3 %
Net Profit Margin \((80,000 \div 600,000) \times 100\) 13.3 %
Capital Employed Total Assets – Current Liabilities = \(400,000 - 80,000\) 320,000
ROCE \((80,000 \div 320,000) \times 100\) 25 %
Gearing (Debt‑to‑Equity) \((150,000 \div 250,000) \times 100\) 60 %
Dividend Cover \(80,000 \div 30,000\) 2.67 times

Interpretation – XYZ Ltd converts its investment in inventory and receivables into cash in about 39 days. The current ratio is satisfactory, but the quick ratio (<1) shows reliance on inventory for short‑term liquidity. A gearing of 60 % is moderate, and dividend cover of 2.7 indicates a comfortable ability to maintain the current dividend.

5. Key Take‑aways

  • Focus on the three components of the Cash Conversion Cycle (DIO, DSO, DPO) – reducing any one shortens the overall cycle.
  • Improvement actions must be balanced: tighter inventory or credit control can improve ratios but may hurt sales or supplier relationships.
  • Always benchmark ratios against industry averages and adjust for seasonality to avoid misleading conclusions.

6. Suggested Diagram – Cash Conversion Cycle Flowchart

Purchase of raw material → Production → Inventory → Sales → Receivables → Cash collection → Payables settlement → Cash on hand. Each stage is linked to the relevant efficiency ratio (DIO, DSO, DPO, CCC).

Appendix A – Other Useful Ratios (for broader analysis)

Ratio Category Formula Brief purpose
Current Ratio Liquidity \(\displaystyle \frac{\text{Current Assets}}{\text{Current Liabilities}}\) Short‑term solvency.
Quick Ratio Liquidity \(\displaystyle \frac{\text{Current Assets}-\text{Inventory}}{\text{Current Liabilities}}\) Liquidity without relying on stock.
Gross Profit Margin Profitability \(\displaystyle \frac{\text{Gross Profit}}{\text{Net Sales}}\times100\) Control of production/purchasing costs.
Net Profit Margin Profitability \(\displaystyle \frac{\text{Net Profit}}{\text{Net Sales}}\times100\) Overall profitability after all expenses.
ROCE Profitability \(\displaystyle \frac{\text{Operating Profit}}{\text{Capital Employed}}\times100\) Efficiency of capital utilisation.
Gearing (Debt‑to‑Equity) Gearing \(\displaystyle \frac{\text{Total Debt}}{\text{Equity}}\times100\) Proportion of finance that is borrowed.
Dividend Yield Investment \(\displaystyle \frac{\text{Dividend per Share}}{\text{Market Price per Share}}\times100\) Cash return to shareholders.
Dividend Cover Investment \(\displaystyle \frac{\text{Profit after Tax}}{\text{Dividends Paid}}\) Ability to pay dividends from earnings.
P/E Ratio Investment \(\displaystyle \frac{\text{Market Price per Share}}{\text{Earnings per Share}}\) Market’s expectation of future earnings.

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