Efficiency ratios are financial indicators that are used to assess how effectively a business is managing its assets and liabilities to produce income. Investors, creditors, and other stakeholders can learn more about the financial performance and health of a company by examining these measures. Three important efficiency ratios—Trade Receivable Day, Trade Payable Day, and Inventory Turnover—will be the topic of this blog post. We'll go over how to calculate them and what they indicate about a company's efficiency.
Learn more by watching the video and reading the blog post below:
Trade Receivable Days
Shows how long it takes a company's debtors on average to pay. To put it another way, how long does it take on average for the customers who purchased goods and services from the business on credit to pay?
For instance, if the result of this calculation is 29, this means that it takes the company's customers an average of 29 days to pay for the goods and services they purchased on credit.
The lower the figure for trade receivables, the better. In other words, the faster it receives money from its debtors, the better. As a result, the company is collecting money from its debtors more quickly and in less time.
The following is the formula for Trade Receivable Days:
Trade Receivable Days = (trade receivables / credit sales) x 365
Watch the video for an example of the calculation based on a business scenario.
Trade Payable Days
Shows how long it takes the company on average to pay its creditors for goods and services purchased on credit. If the result of this calculation is 15, then this means that the company takes an average of 15 days to pay for the goods and services purchased on credit.
The higher the figure for trade payables, the better. In other words, the longer it takes to repay creditors, the better as this indicates that the company is keeping its own money for a longer period of time.
Simply put, the golden rule in business is to collect money from debtors as soon as possible and keep money from creditors for as long as possible. To put it another way, the goal is to keep the trade receivables day figure as low as possible and as high a trade payables figure as possible.
This means that a company can put this money to good use such as earning extra interest in a savings account, investing it in other areas of the business, and having it on hand to cover unexpected costs rather than being recorded in the accounts of its debtors and creditors.
The following is the formula for Trade Payable Days:
Trade Payable Days = (trade payables / credit sales) x 365
Watch the video for an example of the calculation based on a business scenario.
Inventory Turnover
Shows the average number of days a business holds an item of stock. If the result of the inventory turnover calculation is 3, this means that the company keeps each item of stock for an average of 3 days. Whether you think this figure is good or bad, is determined by the nature of the business and the products it sells.
A florist, for example, is likely to have a much lower inventory turnover than a car dealership. However, in general, the lower the inventory turnover figure, the better for the business because it indicates a higher stock turnover.
In other words, the company is selling its inventory more quickly due to regular sales being made to customers.
The following is the formula for Trade Payable Days:
Inventory Turnover = Average Inventory / Cost of Sales
Watch the video for an example of the calculation based on a business scenario.
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