Answers to self-test questions
6.6 Assessing efficiency
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Example
A company is about to invest in a new machine. This will cost
£1,000 and will last for five years, after which time it will have no value. During its five-year life the machine will generate an annual profit of £100, after taking account of depreciation.
The return on the capital employed in this machine for each of the five years could be calculated as follows:
Net book value
End of year of machine ROCE
£ %
1 (£1,000£200) 800 (100⁄800) 12.5
2 (£800£200) 600 (100⁄600) 16.7
3 (£600£200) 400 (100⁄400) 25.0
4 (£400£200) 200 (100⁄200) 50.0
5 (£200£200) 0 (100⁄0) infinite
The annual depreciation charge is (£1,0005) £200. This is the amount by which the net book value is reduced each year.
This simple example demonstrates that the lower the net book value of the asset, the higher will be the ROCE for a given level of profit. Therefore new capital investment can depress the ROCE in the short term, and if assets are undervalued then the ROCE may be misleadingly high.
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6.6.1 Stock (inventory) turnover period
This ratio measures the average number of days’ inventory held on the balance sheet date. It can be calculated for LMN in Year 2 as follows:
44 days This means that, based on the average cost of sales per day during Year 2, the year-end inventories represented 44 days’ worth of sales.
However it is important to bear in mind that this ratio is based on year-end balance sheet data. The inventory held on this particular date may not be representative of what has been held during the year. Another problem with the calculation is that it assumes that sales are made at an even rate throughout the year.
Therefore the result of the calculation is not particularly accurate.
However it is the best we can do with the data that is available from a published income statement and balance sheet.
Stock turnover period Stock
Cost of sales per day 12 (100/365)
Exercise
Calculate LMN’s stock (inventory) turnover period for Year 3.
Solution
Stock turnover period for Year 3 16
(175/365) 33 days Generally a low inventory turnover period is preferable, that is inventory should be held for the shortest time possible. The ability to manage a business on very low inventories depends, among other things, on the quality of the management information systems and on the closeness of relationships with suppliers and their reliability.
Exercise
Can you think of reasons why inventory should be held for the shortest time possible? And can you think of when this policy might lead to problems?
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6.6.2 Debtors (receivables) collection period
The receivables collection period measures how long, on average, credit customers take to settle their bill and is calculated as follows:
Debtors collection period Trade debtors Credit sales per day Solution
Your reasons for a short inventory period may have included the following:
◆ Capital tied up in inventory could be used more effectively elsewhere.
◆ The longer inventory is held, the more likely it is to become unusable or obsolete. This is particularly important with perishable items or fashion goods.
◆ Higher inventory will generally incur higher storage costs, higher insurance costs, etc.
If inventories are too low this could lead to the following problems:
◆ Inventory may run out, leading to lost opportunities or the need to make emergency purchases at higher prices.
◆ If goods are purchased in small quantities, bulk discounts may be forgone and ordering costs may be high.
Exercise
Assuming that all LMN’s sales are made on credit, calculate the receivables collection period for Years 2 and 3.
Solution
Year 2 18
(150/365) 44 days
Year 3 (25040/365) 58 days On average, it took longer to collect debts from customers in Year 3 than in Year 2. This can have a detrimental effect on the cash flows
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and liquidity of the company. Furthermore, the longer a credit customer takes to pay, the higher the risk that the customer will run into financial difficulties and be unable to pay.
Once again it is important to bear in mind the inadequacies of the balance sheet figure in calculating the number of days’ debt. The resulting figure is an average which may not be representative of the year as a whole. Also it might be distorted by the existence of, say, one large customer who is exceptionally slow to pay.
6.6.3 Creditors (payables) payment period
The debtors (receivables) collection period could be compared with the creditors (payables) payment period:
Management sometimes try to ensure that the two periods are roughly equal, or that the payables period is slightly longer, that is that the organisation takes longer to pay its bills than it takes to collect money from its customers, resulting in interest-free credit for a period.
However, this policy should not be pursued to extremes. The organisation may gain a reputation for being a slow payer resulting in higher prices, or the supplier might even curtail supplies.
The data that we have for LMN does not show the purchases made each year. This is often the case with published accounts and it is commonly accepted that a reasonable approximation is to use instead the figures for cost of goods sold.
Creditors payment period Trade creditors Credit purchases per day
Exercise
Using cost of goods sold instead of purchases in the above formula, calculate the average creditors (payables) payment period for LMN in Years 2 and 3.
Solution
Year 2 10.2
(100/365) 37 days
Year 3 (17528/365) 58 days
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The average payment period for suppliers has shown a substantial increase. In Year 3 LMN took, on average, nearly two months to pay for its purchases.
Remember that the use of balance sheet data presents the same interpretation problems with this ratio as with the receivables collection period. For example, the calculation can be distorted by the company taking a longer period of credit from one or two larger suppliers.
6.6.4 Fixed (non-current) asset turnover
This ratio monitors how effectively a company uses its non- current assets. It is calculated as follows.
Fixed asset turnover Sales revenue Fixed assets
Exercise
Calculate the fixed (non-current) asset turnover for LMN in Years 2 and 3.
Solution
Fixed asset turnover for Year 3 250
85 2.9 times Fixed asset turnover for Year 2 150
52 2.9 times
6.6.5 LMN’s efficiency ratios: Summary
The ratios that we have calculated for Years 2 and 3 are as follows:
Year 2 Year 3
Stock (inventory) turnover period 44 days 33 days Debtors (receivables) collection period 44 days 58 days Creditors (payables) payment period 37 days 58 days
Fixed asset turnover 2.9 times 2.9 times
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Exercise
What outline conclusions can you draw about LMN’s management of its working capital and non-current asset resources in Years 2 and 3?
Solution
Debtor (receivables) levels appear to be increasing out of control, although this may be a deliberate and controlled increase as part of a policy to encourage increased sales revenue.
Inventory levels appear to have reduced. This indicates efficient control of working capital, although sales may be forgone if customer requirements cannot be met from inventory. The reduction in the inventory turnover period has contributed to the improvement in the company’s asset turnover.
Creditor (payables) levels have been reasonably well matched with debtors. However, supplier relationships may be harmed if the credit period becomes excessive. The increase in the period of credit taken from suppliers has contributed to the improvement in the company’s asset turnover.
The utilisation of fixed assets continues at approximately the same level. The level of investment in fixed assets has increased but the revenues have increased correspondingly and a broad conclusion can be drawn that it appears that the new assets are being used in an efficient way to generate revenue.