CIMA BA3 Syllabus D. ANALYSIS OF FINANCIAL STATEMENTS - Efficiency Ratios. - Notes ^{3 / 5}

Inventory Turnover Period

Closing (or average) Inventory x 365
---------------------------------------
COS                                     

This ratio calculates how long goods to be sold stay in stock.

Generally, the lower the number of days that inventory is held the better as holding inventory for long periods of time constrains cash flow and increases the risk associated with holding the inventory. 

The longer inventory is held the greater the risk that it could be subject to theft, damage or obsolescence. 

However, a business should always ensure that there is sufficient inventory to meet the demand of its customers.

Receivables Collection Period (in days)

Trade Receivables x 365
------------------- 
Credit Sales 

This ratio calculates how long credit customers take to pay.

A short credit period for receivables will aid a business’ cash flow. 

However, some businesses base their strategy on long credit periods to achieve higher sales in highly competitive markets.

If the receivables days are shorter compared to the prior period, it could indicate better credit control or potential settlement discounts being offered to collect cash more quickly whereas an increase in credit periods could indicate a deterioration in credit control or potential bad debts

Payables Payment Period (in days)

Trade Payables x 365
---------------------
Credit Purchases 

This ratio calculates how long the company takes to pay its suppliers.

An increase in payables days could indicate that a business is having cash flow difficulties and is therefore delaying payments. 

It is important that a business pays within the agreed credit period to avoid conflict with suppliers. 

If the payables days are reducing, this indicates suppliers are being paid more quickly. 

This could be due to credit terms being tightened or taking advantage of early settlement discounts being offered.

Working Capital Cycle (cash cycle)

A company only gets cash once an item has been in stock and then the debtor pays (Inventory days + receivables days).

This total should then be reduced by the payable days (the company doesn’t need the cash until the end of this).

So, the working capital cycle (in days) is:

Inventory (in days) + Receivables (in days) – Payables (in days)

This needs to be kept as small as possible for liquidity purposes.