DEBT/EQUITY RATIO ANALYSIS Flashcards
Efficiency Ratios
Asses how well a firm internally utilizes its assets and liabilities. They also help analyze the performance of a firm.
Types: Stock turnover, Debtor days. Creditors days an Gearing ratio.
Stock turnover Ratio
Measures how quickly a firm’s stock is sold and replaced over a given period.
A high stock turnover means that the firm sells stock quickly, thereby earning more profits from sales.
Also means that goods don’t become obsolete quickly. The firm has good control over its purchasing decisions.
Stock Turnover Ratio (Number of times)
cost of sales / average stock
Average Stock
(opening stock + closing stock) / 2
Stock Turnover Ratio (Number of days)
average stock / cost of sales x 365
Strategies to improve stock turnover
- Get rid of obsolete goods. Help reduce the firm’s level of stock. Could lead to losses due to the lost sales revenue that these goods could’ve generated.
- Offer a narrower, better selling range of products. However, it may minimize the variety of products offered to customers.
- Keeping low levels of stock, reduces costs of holding stock. However, in sudden increases of demand businesses with low levels of stock won’t be able to support market demands.
- Just-in-time production method. Stocks of raw materials are only ordered when needed. However, delays in delivery can negatively affect production and eventually sales.
Debtor Days
The number of days it takes on average for a firm to collect its debts from customers it has sold goods to on credit. It assesses how efficient a business is in its credit control systems.
The shorter the debtor days the better. Provides business with working capital to run its day to day operations.
Debtors
An individual or an organisation who has bought on credit (or received a loan) from the business and owes the business money.
How long should the credit period be for debtors?
30-120 days. Too long credit operations can lead to severe cashflow problems and a liquidity crisis.
Debtors Ratio Formula
Debtors / Total Sales Revenue x 365
Startegies to improve Debtor days ratio
- Provide discounts and other incentives to encourage debtors to pay their debts earlier. However, the business receives less income than what was originally agreed.
- Can impose stiff penalties, such as fines for late payers. Might lose long-time loyal customers.
- Stop any further transactions with overdue debtors until payment is finalized. Still does not guarantee payment though.
- Resort to legal means, such as court action for consistently late payers. May harm the reputation of a business.
Creditor Days
The average number of days a firm takes to pay its creditors. Asseses how quickly a firm is able to pay its suppliers.
High creditor days enables the firm to use available cash to fulfill its short term obligations. However, extending the period for too long may strain the relationship with the creditors/suppliers. Can lead to financial problems and a bad reputation with investors.
Startegies to improve creditor days ratios
- Good relationships with creditors to negotiate extended credit periods. However, suppliers could object to the extension and refuse to support the business in the future.
- Effective credit control. Managers will need to asses the risks of paying creditors early versus how long they should delay in making their payment. Not an easy task and will depend on cashflow position and needs of the business at the time.
Creditor Days Formula
Creditors days ratio = creditors / cost of sales x 365
Gearing Ratio
Measures the extent to which the capital employed by a firm is financed from loan capital.
Loan capital is a non current liability in the business, while capital employed includes loan capital, shared capital and retained profits.
