3.6: Debt/Equity Ratio Analysis

Efficiency ratios

Efficiency ratios assess how efficiently a business uses its resources. They are particularly helpful in evaluating the use of assets and liabilities.
Key efficiency ratios:
Stock turnover ratio: Measures how quickly inventory is sold.
Debtor days ratio: Measures the average time it takes to collect payments from customers.
Creditor days ratio: Measures the average time it takes to pay suppliers.
Gearing ratio: Measures the proportion of debt to equity in the company's capital structure.
These ratios are essential for understanding a business's financial stability and its ability to manage its resources effectively.

The stock turnover ratio measures how efficiently a business sells and replenishes its inventory. It can be calculated using either the number of times inventory is sold per year or the average number of days to sell inventory.
Key points:
Higher stock turnover: Generally better, indicates efficient sales.
Lower stock turnover (days): Better for perishable goods.
Factors affecting stock turnover: Pricing, product range, demand, and supply chain efficiency.
Context matters: Ideal stock turnover varies by industry and business type.
Businesses should strive to optimize their stock turnover to balance inventory levels with sales efficiency.

Formula: (Cost Of Goods Sold/ Average Inventory)

The debtor days ratio measures how long it takes a business to collect money from its customers who have bought items on credit. It is calculated by dividing the total debtors by the total sales revenue and multiplying by 365. A lower debtor days ratio is better for the business because it means customers are paying their debts faster, improving cash flow and reducing the opportunity cost of holding onto the money.

Formula: (Trade Receivables/Sales) x 100

The creditor days ratio measures how long it takes a business to pay its suppliers. It is calculated by dividing the total creditors by the cost of goods sold and multiplying by 365. A higher creditor days ratio means the business is taking longer to pay its suppliers, which can harm its cash flow position if suppliers impose penalties for late payment.
However, a higher creditor days ratio can also free up cash for other uses in the short term. Strategies to improve the creditor days ratio include developing closer relationships with suppliers, introducing a just-in-time production system, and improving credit control.

Formula : (Trade Payables/Cost Of Sales) x 365

The gearing ratio measures a company's long-term liquidity by assessing the proportion of its capital financed by long-term debt.
A high gearing ratio means a company relies heavily on external financing, which can increase costs due to interest repayments and expose the company to financial risks like interest rate hikes or economic downturns.
However, high gearing can also benefit a company by allowing it to grow and potentially generate higher returns. The acceptable level of gearing depends on factors like the company's size, interest rates, and potential profitability.

Formula: (Long Term Liabilities/Capital Employed) x100

Insolvency vs. Bankruptcy
Insolvency occurs when a business is unable to pay its debts due to insufficient funds or cash flow. It can be caused by cash flow insolvency (unable to make payments) or balance sheet insolvency (liabilities exceed assets).
Bankruptcy is a legal declaration of insolvency, meaning the business cannot pay its debts even if it sold all its assets. It's a last resort after all other attempts to address insolvency fail.
Key Differences:
Financial State: Insolvency is a financial state, while bankruptcy is a legal process.
Legal Consequences: Bankruptcy has more severe legal consequences, including potential credit damage for business owners.
Relationship: A business can be insolvent without being bankrupt, but it cannot be bankrupt without first being insolvent.
Liquidity and Working Capital:
Liquidity: Refers to how easily assets can be converted to cash. Highly liquid assets can be quickly converted without losing value.
Working Capital: The difference between a firm's current assets and current liabilities. Insufficient working capital is a common cause of business failure.
Working Capital Cycle: The time lag between paying for production costs and receiving cash from sales. Businesses must manage their working capital carefully to avoid insolvency.