Efficiency Ratios Explained | Trade Receivable Day, Trade Payable Days, and Inventory Turnover.

Summary

This video explains three key efficiency ratios that businesses use to measure financial performance: trade receivable days, trade payable days, and inventory turnover. These ratios help assess how efficiently a business manages its assets and liabilities. Trade receivable days show how quickly customers pay their debts, trade payable days reflect how long a business takes to settle its own debts, and inventory turnover indicates how fast a business sells its stock. The video provides practical examples, using the fictional business Tom's Tops, to illustrate how each ratio is calculated and what the results imply for business management.

Takeaways

• 😀 Efficiency ratios measure how effectively a business uses its current assets and liabilities.
• 😀 Key efficiency ratios include trade receivable days, trade payable days, and inventory turnover.
• 😀 Trade receivable days shows how quickly customers pay for goods or services purchased on credit.
• 😀 A lower trade receivable days figure is better for a business, as it means faster collection of owed money.
• 😀 The trade receivable days formula is: (Trade Receivables / Credit Sales) * 365.
• 😀 A higher trade payable days figure is generally better for a business, as it indicates longer holding of cash before paying suppliers.
• 😀 The trade payable days formula is: (Trade Payables / Credit Purchases) * 365.
• 😀 Inventory turnover shows how quickly a business sells its stock, and the lower the turnover, the better.
• 😀 The inventory turnover formula is: (Average Inventory / Cost of Sales) * 365.
• 😀 To calculate average inventory, add opening and closing inventory, then divide by two.
• 😀 Efficiency ratios help businesses maintain healthy cash flow by balancing quick collections with slower payments to creditors.

Q & A

What are efficiency ratios in business?

Efficiency ratios are key financial metrics that measure how effectively a business uses its assets and liabilities. They assess how well a company manages its resources, such as trade receivables, trade payables, and inventory turnover.

What does the trade receivable days ratio measure?

The trade receivable days ratio measures the average number of days it takes for a business to collect payments from its customers who have bought goods or services on credit.

How is the trade receivable days ratio calculated?

The trade receivable days ratio is calculated by dividing the trade receivables by credit sales, then multiplying the result by 365.

Why is it better for the trade receivable days ratio to be low?

A low trade receivable days ratio means that the business is collecting money from customers faster, which improves cash flow and liquidity.

What is the golden rule for managing trade receivables and payables?

The golden rule is to collect money from debtors as quickly as possible and to hold on to money from creditors as long as possible, without breaching the agreed terms.

What does the trade payable days ratio measure?

The trade payable days ratio measures the average number of days it takes for a business to pay its suppliers for goods and services purchased on credit.

How is the trade payable days ratio calculated?

The trade payable days ratio is calculated by dividing trade payables by credit purchases, then multiplying the result by 365.

Why is a high trade payable days ratio generally better for a business?

A high trade payable days ratio indicates that a business is holding onto its cash for a longer period, which can be beneficial for managing liquidity and financing other operations.

What does inventory turnover indicate?

Inventory turnover indicates how quickly a business sells its stock. A lower turnover rate typically means the business is selling inventory more quickly.

How do you calculate the inventory turnover ratio?

The inventory turnover ratio is calculated by dividing the average inventory by the cost of sales, then multiplying the result by 365.

What are the implications of a high or low inventory turnover ratio?

A high inventory turnover ratio suggests that a business is selling products quickly, which is generally good. However, it may also indicate that the business is not keeping enough stock. A low ratio suggests that stock is sitting unsold for longer periods, which could lead to inefficiency or outdated inventory.