Business 3.6 Flashcards
What are the 4 efficiency ratios
Stock turnover
Debtor days
Creditor days
Gearing
Strategies to improve stock turnover
The low-risk strategy to improve stock turnover ratio is to hold lower stock levels.
This can be achieved in different ways, for example by selling goods with a discount in order to speed up sales. The downside of this strategy is that revenues and profits might decrease despite the increase in speed of generating profits.
Implement just-in-time (JIT) production to improve stock turnover.
JIT Explained: This method involves holding no stocks of raw materials or finished goods, ordering supplies only as needed and only in quantities required for short-term production.
Advantages: JIT is effective when suppliers are reliable and the infrastructure supports quick deliveries.
Risks: Heavy reliance on suppliers and the potential inability to meet demand if there’s a sudden increase.
What are debtor days ratio
Shows how long it takes to collect debts
Strategy to improve debtor days ratio
The low-risk strategy to improve debtor days ratio is to offer discounts to customers in exchange for early payments. This way, they will be motivated to pay earlier and you might avoid the situation of bad debt.
However, discount always means lower revenues, so it is really important to keep balance and make sure that discount is significant enough to motivate early payments, but insignificant enough to have a negative effect on revenues.
The high-risk strategy is to threaten your customers (debtors) with a lawsuit in case they miss the payment deadline. In the short term, you will definitely get your debts back because the law will be on your side (if there is an a contract with your customers that clearly states credit period).
On the other hand, in the long term, after threatening someone with legal action, it would be hard to maintain a good trustworthy relationship… So, your customers might be looking for other suppliers, if you threaten to sue them too often.
What is Creditor days ratio (payables)
Shows how long it takes to pay creditors
Strategies to improve creditor days:
- Negotiating longer credit periods: Can try develop better relationship to achieve this. But, may threaten relationships with suppliers.
- Just-in-time stock system: Stock only ordered when needs, avoid of excess stocks. But, may cause delay in supply chains which reduce sales revenue and cause customer dissatisfaction.
- Looking for different suppliers: Might help business get better credit terms and extend credit periods. But, there are a lot of uncertainty, too.
What does longer creditor day mean for a business
better for business → cash not spent on working capital cycle → less pressure of WCC
What does shorter creditor days mean for a business
Reduce available cash
What is gearing ratio
efficiency ratio that measures the extent to which an organisation is financed by external sources of finance.
What does high gearing ratio mean for a business
Higher GR = more of business operations are long-term debts, too much risk to interests rates = could also some chance of high returns
What does low gearing ratio mean for a business
Low GR means there is available cash to invest, not enough money being used
Strategies to improve the gearing ratio:
- Paying off liabilities: Reduce gearing ratio. But paying of long-term liabilities means less cash for daily operations which can reduce sales revenue.
- Increase retained profit by not issuing dividends: Achieved through minimising cost to increase revenue. But, this means reducing dividends which could cause shareholders to be unhappy.
- Selling more shares: Increases capital employed, consequently, decreases gearing ratio. But, selling more shares will cause dilution of control and reduced dividends to shareholders.
Give % for gearing ration considered high low and good
- 25% considered low, 25% - 50% considered normal (well-established), 50%+ considered high
- Normal ratio is important because the business is making good use of its finance while also having enough money for future investments
What is insolvency
refers to the situation where a person or a business is unable to meet their bill and other debt obligations. The debts of the individual or organisation exceed their assets.
- Working capital cycle not function efficiently → insolvent
- Last resort is liquidation for insolvent businesses.
Situations that results in insolvency:
- Debtor days too long: Customer take too long to pay products which reduces cash flow of business.
- Loss of sales revenue: Due to internal factors such as poor quality products/high labour turnover or external factors such as increase competition/poor economic condition.
- Increased costs: Could be both internal factors (operations mismanagement) and external factors (poor economic environment, competition, etc).
- Legal action: If business is sued, it is forced to pay high legal fees.
- Loss of customers: Switched goods due to changing needs and market trends.
- Global and local chain issue: Prevents business from being able to trade.
