Efficiency (Activity) ratios
Learning objective
By the end of this module, you should be able to:
- Calculate key accounting ratios related to efficiency
- Calculate and interpret the relationship between the elements of the financial statements regarding profitability, liquidity, efficient use of resources, and financial position.
- Draw valid conclusions from the information contained within the financial statements and present these to the appropriate user of the financial statements.
Illustration: Financial statement analysis
Sokoto Company Limited is a manufacturing company that has been operating for several years. The company’s financial controller has prepared the financial statements for the year ended 31 December 2024. As a financial analyst, you have been asked to evaluate the company’s efficiency and working capital management for the period.
The following financial statements have been provided for your analysis:
Statement of profit or loss and other comprehensive income
| $ | |
|---|---|
| Sales revenue | 935,200.00 |
| Cost of sales | (442,300.00) |
| Gross profit | 492,900.00 |
| Distribution cost | (151,000.00) |
| Administrative expenses | (213,192.00) |
| Operating profit | 128,708.00 |
| Profit before financing and income taxes | 128,708.00 |
| Finance expense | (16,000.00) |
| Profit before income taxes | 112,708.00 |
| Income tax for the year | (51,600.00) |
| Profit after tax | 61,108.00 |
| Other comprehensive income | |
| Revaluation surplus | 50,000.00 |
| Total comprehensive income | 111,108.00 |
Statement of financial position as at 31 December 2024
| $ | $ | |
|---|---|---|
| Non-current asset: | ||
| Property, plant and equipment | 522,800.00 | |
| Current asset: | ||
| Inventories | 94,200.00 | |
| Trade receivables | 119,808.00 | |
| Prepaid expenses | 5,800.00 | |
| Cash at bank | 45,200.00 | |
| Total current assets | 265,008.00 | |
| Total asset | 787,808.00 | |
| Equity and liabilities | ||
| Equity: | ||
| Ordinary share capital (50,000 shares) | 200,000.00 | |
| Retained earnings | 189,508.00 | |
| Revaluation surplus | 50,000.00 | |
| Total equity | 439,508.00 | |
| Non-current liabilities: | ||
| 8% debenture | 200,000.00 | |
| Current liabilities: | ||
| Trade payables | 83,300.00 | |
| Accrued expenses | 16,400.00 | |
| Income tax payable | 48,600.00 | |
| Total current liabilities | 148,300.00 | |
| Total equity and liabilities | 787,808.00 |
| Ratio | Industry average |
|---|---|
| Inventory turnover | 5.2 times |
| Inventory days | 70 days |
| Receivables collection period | 50 days |
| Payables payment period | 60 days |
| Cash operating cycle | 60 days |
Required: Calculate the following efficiency (activity) ratios for Sokoto Company Limited for the year ended 31 December 2024:
- Inventory turnover
- Inventory days
- Receivables collection period
- Payables payment period
- Cash operating cycle
- Compare each of your calculated ratios with the industry average provided above and comment on Sokoto Company Limited’s performance relative to the industry.
Suggested solution:
Try calculating the ratios and making the comparisons yourself before reviewing the suggested solution below.
- What is the inventory turnover ratio?
You can find inventory on the statement of financial position and cost of sales on the statement of profit or loss. Note: Since only the closing inventory is provided, the closing inventory is used instead of the average inventory.
Inventory turns 4.7 times, below the industry’s 5.2 times. This points to slower inventory movement than the industry benchmark, consistent with the longer inventory days calculated next.
- What is the inventory days?
You can find inventory on the statement of financial position and cost of sales on the statement of profit or loss.
Inventory days of 78 days is slightly higher than the industry average of 70 days. This points to slower inventory movement than the industry benchmark, so it’s worth checking whether the company is holding excess inventories, carrying slow-moving items, or experiencing seasonal effects.
- What is the receivables collection period?
You can find trade receivables on the statement of financial position and sales on the statement of profit or loss. Note: Credit sales is not given explicitly, so total sales is used.
A receivables collection period of 47 days is better than the industry benchmark of 50 days. This suggests effective credit control and faster cash collection, which supports cash flow and reduces irrecoverable debt risk.
- What is the payables payment period?
You can find trade payables on the statement of financial position. Note: Credit purchases is not given explicitly. Cost of sales is given and is used here.
A payables payment period of 69 days is higher than the industry average of 60 days. This suggests the company is taking longer credit from suppliers and using supplier financing more heavily.
- What is the cash operating cycle?
Now combine the three working-capital timing measures.
A cash cycle of 56 days is slightly below the 60-day industry benchmark. But inventory days plus receivables days (78 + 47 = 125) are longer than the industry’s (70 + 50 = 120), so Sokoto converts inventory and receivables into cash more slowly, not faster. The shorter cycle comes entirely from taking 9 extra days of supplier credit, which should be checked against agreed terms before calling working capital management efficient.
Summary table of the analysis
| Ratio | Sokoto Company Limited | Industry average | Variance |
|---|---|---|---|
| Inventory turnover | 4.7 times | 5.2 times | -0.5 times |
| Inventory days | 78 days | 70 days | +8 days |
| Receivables collection period | 47 days | 50 days | -3 days |
| Payables payment period | 69 days | 60 days | +9 days |
| Cash operating cycle | 56 days | 60 days | -4 days |
Overall assessment: Sokoto’s cash operating cycle (56 days) is slightly shorter than the industry’s (60 days), but only because it takes 9 more days of supplier credit. Its faster collection (47 against 50 days) is more than cancelled by slower-moving inventory (78 against 70 days), and the longer payables period should be checked against agreed supplier terms.
Note: This question only performed an industry-level comparison. In other questions, you may be given information for the same company for two (2) different years. The approach is the same: apply the formulas consistently, compare results, and interpret whether performance is improving or worsening, what factors may have contributed, and what actions could improve the results.