Financial Analysis

Efficiency Ratios

Summary of formulas

Average inventory = (opening inventory + closing inventory) / 2

Trade receivable days

Measures how long on average customers take to pay for goods bought on credit.

• Benchmark: 30 days (standard credit terms)
• Benefits of fewer days: better cash flow; reduced bad debt risk; implies strong credit control
• Trade-off: may require offering a cash discount (discount allowed) to incentivise prompt payment → reduces cash inflows and profit

Trade payable days

Measures how long on average the business takes to pay suppliers for credit purchases.

• More days can improve cash flow by delaying outflows to suppliers

Disadvantages of taking too long to pay:

• Loss of cash discount (discount received) — would have reduced purchases cost and increased profit
• Interest charged on late payment
• Poor credit rating / being blacklisted
• Supplier may stop supplying or insist on cash-only terms
• Difficulty finding alternative suppliers

Key principle: receivable days should ideally be fewer than payable days — customers pay before the business must pay its suppliers, improving overall liquidity.

Rate of inventory turnover

Measures how quickly inventory is sold on average from the business.

• Higher turnover = faster selling = better (more sales; lower holding costs)
• Can also be expressed in days: 365 ÷ turnover rate

Benefits of faster inventory turnover:

• Higher sales volume implied
• Lower inventory holding costs (storage, insurance, wages)
• Reduced risk of inventory deterioration (perishables) or obsolescence (technology, fashion)
• Reduces opportunity cost — cash not tied up in unsold stock

Risks of very low inventory levels:

• Stockout risk → lost sales, damaged reputation, customers seek alternative suppliers
• JIT (just-in-time) systems are not captured by this ratio

Worked example (Geraint Roglic)

Receivable days (45) > payable days (42) — the business pays suppliers before collecting from customers, which is unfavourable for cash flow.