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.

Definitions

Efficiency ratios: These are a group of ratios that measure how effectively a company uses its assets and manages its expenses to generate revenue. This group of ratios includes:

Inventory turnover
Inventory days
Receivables collection period
Payables payment period

Inventory turnover: This measures the number of times a company sells and replaces its inventory over a specific period (typically a year). It shows how quickly inventory is converted into sales.Formula:

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: A higher turnover ratio suggests inventory is sold quickly, which may indicate strong sales and effective inventory management. A lower turnover ratio may signal weak sales or excess stock. A lower ratio might indicate holdings of obsolete or unsaleable inventory, though it could also reflect a strategic purchase of raw materials in anticipation of price increases.

Inventory days: This measures the average number of days inventory is held before it is used or sold. This ratio is expressed in days, using 365 days in a year.Formula:

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: The lower the number of days, the better. A higher number of inventory days might indicate holdings of obsolete or unsaleable inventory, but it might also reflect buying raw materials early in anticipation of a price increase or inventory still in the production process.

Receivables collection period: This measures the average number of days it takes customers to pay what they owe. Overall, it indicates how effectively short-term debts are being collected.

Formula:

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

Interpretation: The lower the number of days, the better, because it indicates faster debt collection. A higher number of days (assuming the proportion of cash sales has not increased) indicates receivables are taking longer to pay. You’d typically investigate the terms of trade (credit policy) and whether there are long-outstanding debts that require provisions.

Payables payment period: This measures the average number of days it takes the company to pay its suppliers. It shows how much credit the company is taking. Overall, it reflects the company’s bargaining power with suppliers and its creditworthiness.

Formula:

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

Interpretation: The higher the number of days, the better. An increase in days may indicate greater reliance on payables to finance the business. A decrease in days may indicate the company is taking cash discounts, or it may indicate suppliers are reducing credit terms because of the company’s decreased creditworthiness.

Cash operating cycle: Also referred to as the Cash Conversion Cycle (CCC) or Cash Cycle, this represents the number of days a company takes to turn cash spent on inventory into cash collected from sales. It helps you assess working capital management by tracking the time between paying suppliers and collecting from customers.Formula:

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

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 profitability performance 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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	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
Accounts 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:
Account 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	3 times
Inventory days	70 days
Receivables collection period	50 days
Payables payment period	60 days
Cash operating cycle	60 days

Required: Calculate the following liquidity 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?

(spoiler)

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

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 turnover = \frac{$442 , 300}{$94 , 200} = 4.70 times$

Inventory turns 4.7 times, above the industry’s 3 times. This suggests faster stock movement and more efficient inventory management, which can reduce holding costs and lower the risk of obsolescence.

What is the inventory days?

(spoiler)

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

You can find inventory on the statement of financial position and cost of sales on the statement of profit or loss.

$Inventory Days = \frac{$94 , 200}{$442 , 300} \times 365 days = 78 days$

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 stock, carrying slow-moving items, or experiencing seasonal effects.

What is the receivables collection period?

(spoiler)

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

You can find accounts receivable 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.

$Receivables collection period = \frac{$119 , 808}{$935 , 200} \times 365 days = 47 days$

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 bad debt risk.

What is the payables payment period?

(spoiler)

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

You can find accounts payable on the statement of financial position. Note: Credit purchases is not given explicitly. Cost of sales is given and is used here.

$Payables payment period = \frac{$83 , 300}{$442 , 300} \times 365 days = 69 days$

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?

(spoiler)

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Now combine the three working-capital timing measures.

$Cash Operating Cycle = 78 days + 47 days - 69 days = 56 days$

A cash cycle of 56 days, slightly below the 60-day industry benchmark, indicates relatively efficient working capital management. The company converts inventory and receivables into cash a little faster than the industry average.

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Inventory Turnover	4.69 times	3.0 times	+1.69 times	Above industry average - More efficient inventory management
Inventory Days	78 days	70 days	+8 days	Above industry average - Slower inventory movement
Receivables Collection Period	47 days	50 days	-3 days	Below industry average - Faster debt collection
Payables Payment Period	69 days	60 days	+9 days	Above industry average - Longer credit terms utilized
Cash Operating Cycle	56 days	60 days	-4 days	Below industry average - More efficient working capital management

Overall Assessment: Sokoto Company Limited demonstrates excellent working capital management with efficiency ratios that generally outperform industry benchmarks. The company collects cash from customers relatively quickly and makes effective use of supplier credit, resulting in a shorter cash operating cycle than the industry average. The slightly higher inventory holding period is the main area to investigate, but overall, the company’s working capital efficiency supports liquidity and reduces the need for additional financing.

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.

Efficiency ratios measure how effectively a company uses assets and manages expenses to generate revenue and sales.
Inventory turnover = Cost of Sales ÷ Average Inventory. Higher ratios indicate faster sales and efficient inventory management.
Inventory days = (Average Inventory ÷ Cost of Sales) × 365. Lower days indicate faster inventory conversion to sales.
Receivables collection period = (Accounts Receivables ÷ Credit Sales) × 365. Lower days indicate efficient debt collection practices.
Payables payment period = (Accounts Payables ÷ Credit Purchases) × 365. Higher days show better supplier credit utilization.
Cash operating cycle = Inventory Days + Receivables Period - Payables Period. Lower cycles indicate superior working capital efficiency.

Next | 9.5 Gearing ratios

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.

Definitions

Efficiency ratios: These are a group of ratios that measure how effectively a company uses its assets and manages its expenses to generate revenue. This group of ratios includes:

Inventory turnover
Inventory days
Receivables collection period
Payables payment period

Inventory turnover: This measures the number of times a company sells and replaces its inventory over a specific period (typically a year). It shows how quickly inventory is converted into sales.Formula:

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: A higher turnover ratio suggests inventory is sold quickly, which may indicate strong sales and effective inventory management. A lower turnover ratio may signal weak sales or excess stock. A lower ratio might indicate holdings of obsolete or unsaleable inventory, though it could also reflect a strategic purchase of raw materials in anticipation of price increases.

Inventory days: This measures the average number of days inventory is held before it is used or sold. This ratio is expressed in days, using 365 days in a year.Formula:

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: The lower the number of days, the better. A higher number of inventory days might indicate holdings of obsolete or unsaleable inventory, but it might also reflect buying raw materials early in anticipation of a price increase or inventory still in the production process.

Receivables collection period: This measures the average number of days it takes customers to pay what they owe. Overall, it indicates how effectively short-term debts are being collected.

Formula:

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

Interpretation: The lower the number of days, the better, because it indicates faster debt collection. A higher number of days (assuming the proportion of cash sales has not increased) indicates receivables are taking longer to pay. You’d typically investigate the terms of trade (credit policy) and whether there are long-outstanding debts that require provisions.

Payables payment period: This measures the average number of days it takes the company to pay its suppliers. It shows how much credit the company is taking. Overall, it reflects the company’s bargaining power with suppliers and its creditworthiness.

Formula:

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

Interpretation: The higher the number of days, the better. An increase in days may indicate greater reliance on payables to finance the business. A decrease in days may indicate the company is taking cash discounts, or it may indicate suppliers are reducing credit terms because of the company’s decreased creditworthiness.

Cash operating cycle: Also referred to as the Cash Conversion Cycle (CCC) or Cash Cycle, this represents the number of days a company takes to turn cash spent on inventory into cash collected from sales. It helps you assess working capital management by tracking the time between paying suppliers and collecting from customers.Formula:

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Illustration: Financial statement analysis

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	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
Accounts 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:
Account 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	3 times
Inventory days	70 days
Receivables collection period	50 days
Payables payment period	60 days
Cash operating cycle	60 days

Required: Calculate the following liquidity 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?

(spoiler)

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

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 turnover = \frac{$442 , 300}{$94 , 200} = 4.70 times$

Inventory turns 4.7 times, above the industry’s 3 times. This suggests faster stock movement and more efficient inventory management, which can reduce holding costs and lower the risk of obsolescence.

What is the inventory days?

(spoiler)

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

You can find inventory on the statement of financial position and cost of sales on the statement of profit or loss.

$Inventory Days = \frac{$94 , 200}{$442 , 300} \times 365 days = 78 days$

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 stock, carrying slow-moving items, or experiencing seasonal effects.

What is the receivables collection period?

(spoiler)

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

You can find accounts receivable 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.

$Receivables collection period = \frac{$119 , 808}{$935 , 200} \times 365 days = 47 days$

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 bad debt risk.

What is the payables payment period?

(spoiler)

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

You can find accounts payable on the statement of financial position. Note: Credit purchases is not given explicitly. Cost of sales is given and is used here.

$Payables payment period = \frac{$83 , 300}{$442 , 300} \times 365 days = 69 days$

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?

(spoiler)

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Now combine the three working-capital timing measures.

$Cash Operating Cycle = 78 days + 47 days - 69 days = 56 days$

A cash cycle of 56 days, slightly below the 60-day industry benchmark, indicates relatively efficient working capital management. The company converts inventory and receivables into cash a little faster than the industry average.

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Inventory Turnover	4.69 times	3.0 times	+1.69 times	Above industry average - More efficient inventory management
Inventory Days	78 days	70 days	+8 days	Above industry average - Slower inventory movement
Receivables Collection Period	47 days	50 days	-3 days	Below industry average - Faster debt collection
Payables Payment Period	69 days	60 days	+9 days	Above industry average - Longer credit terms utilized
Cash Operating Cycle	56 days	60 days	-4 days	Below industry average - More efficient working capital management

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.

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9. Interpretation of financial statements

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Efficiency (Activity) ratios

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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.

Definitions

Efficiency ratios: These are a group of ratios that measure how effectively a company uses its assets and manages its expenses to generate revenue. This group of ratios includes:

Inventory turnover
Inventory days
Receivables collection period
Payables payment period

Inventory turnover: This measures the number of times a company sells and replaces its inventory over a specific period (typically a year). It shows how quickly inventory is converted into sales.Formula:

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: A higher turnover ratio suggests inventory is sold quickly, which may indicate strong sales and effective inventory management. A lower turnover ratio may signal weak sales or excess stock. A lower ratio might indicate holdings of obsolete or unsaleable inventory, though it could also reflect a strategic purchase of raw materials in anticipation of price increases.

Inventory days: This measures the average number of days inventory is held before it is used or sold. This ratio is expressed in days, using 365 days in a year.Formula:

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: The lower the number of days, the better. A higher number of inventory days might indicate holdings of obsolete or unsaleable inventory, but it might also reflect buying raw materials early in anticipation of a price increase or inventory still in the production process.

Receivables collection period: This measures the average number of days it takes customers to pay what they owe. Overall, it indicates how effectively short-term debts are being collected.

Formula:

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

Interpretation: The lower the number of days, the better, because it indicates faster debt collection. A higher number of days (assuming the proportion of cash sales has not increased) indicates receivables are taking longer to pay. You’d typically investigate the terms of trade (credit policy) and whether there are long-outstanding debts that require provisions.

Payables payment period: This measures the average number of days it takes the company to pay its suppliers. It shows how much credit the company is taking. Overall, it reflects the company’s bargaining power with suppliers and its creditworthiness.

Formula:

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

Interpretation: The higher the number of days, the better. An increase in days may indicate greater reliance on payables to finance the business. A decrease in days may indicate the company is taking cash discounts, or it may indicate suppliers are reducing credit terms because of the company’s decreased creditworthiness.

Cash operating cycle: Also referred to as the Cash Conversion Cycle (CCC) or Cash Cycle, this represents the number of days a company takes to turn cash spent on inventory into cash collected from sales. It helps you assess working capital management by tracking the time between paying suppliers and collecting from customers.Formula:

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Illustration: Financial statement analysis

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	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
Accounts 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:
Account 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	3 times
Inventory days	70 days
Receivables collection period	50 days
Payables payment period	60 days
Cash operating cycle	60 days

Required: Calculate the following liquidity 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?

(spoiler)

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

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 turnover = \frac{$442 , 300}{$94 , 200} = 4.70 times$

Inventory turns 4.7 times, above the industry’s 3 times. This suggests faster stock movement and more efficient inventory management, which can reduce holding costs and lower the risk of obsolescence.

What is the inventory days?

(spoiler)

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

You can find inventory on the statement of financial position and cost of sales on the statement of profit or loss.

$Inventory Days = \frac{$94 , 200}{$442 , 300} \times 365 days = 78 days$

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 stock, carrying slow-moving items, or experiencing seasonal effects.

What is the receivables collection period?

(spoiler)

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

You can find accounts receivable 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.

$Receivables collection period = \frac{$119 , 808}{$935 , 200} \times 365 days = 47 days$

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 bad debt risk.

What is the payables payment period?

(spoiler)

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

You can find accounts payable on the statement of financial position. Note: Credit purchases is not given explicitly. Cost of sales is given and is used here.

$Payables payment period = \frac{$83 , 300}{$442 , 300} \times 365 days = 69 days$

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?

(spoiler)

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Now combine the three working-capital timing measures.

$Cash Operating Cycle = 78 days + 47 days - 69 days = 56 days$

A cash cycle of 56 days, slightly below the 60-day industry benchmark, indicates relatively efficient working capital management. The company converts inventory and receivables into cash a little faster than the industry average.

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Inventory Turnover	4.69 times	3.0 times	+1.69 times	Above industry average - More efficient inventory management
Inventory Days	78 days	70 days	+8 days	Above industry average - Slower inventory movement
Receivables Collection Period	47 days	50 days	-3 days	Below industry average - Faster debt collection
Payables Payment Period	69 days	60 days	+9 days	Above industry average - Longer credit terms utilized
Cash Operating Cycle	56 days	60 days	-4 days	Below industry average - More efficient working capital management

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.

Efficiency ratios measure how effectively a company uses assets and manages expenses to generate revenue and sales.
Inventory turnover = Cost of Sales ÷ Average Inventory. Higher ratios indicate faster sales and efficient inventory management.
Inventory days = (Average Inventory ÷ Cost of Sales) × 365. Lower days indicate faster inventory conversion to sales.
Receivables collection period = (Accounts Receivables ÷ Credit Sales) × 365. Lower days indicate efficient debt collection practices.
Payables payment period = (Accounts Payables ÷ Credit Purchases) × 365. Higher days show better supplier credit utilization.
Cash operating cycle = Inventory Days + Receivables Period - Payables Period. Lower cycles indicate superior working capital efficiency.

Next | 9.5 Gearing ratios

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.

Definitions

Efficiency ratios: These are a group of ratios that measure how effectively a company uses its assets and manages its expenses to generate revenue. This group of ratios includes:

Inventory turnover
Inventory days
Receivables collection period
Payables payment period

Inventory turnover: This measures the number of times a company sells and replaces its inventory over a specific period (typically a year). It shows how quickly inventory is converted into sales.Formula:

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: A higher turnover ratio suggests inventory is sold quickly, which may indicate strong sales and effective inventory management. A lower turnover ratio may signal weak sales or excess stock. A lower ratio might indicate holdings of obsolete or unsaleable inventory, though it could also reflect a strategic purchase of raw materials in anticipation of price increases.

Inventory days: This measures the average number of days inventory is held before it is used or sold. This ratio is expressed in days, using 365 days in a year.Formula:

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

$*Average Inventory = \frac{Opening Inventory + Closing Inventory}{2}$

Interpretation: The lower the number of days, the better. A higher number of inventory days might indicate holdings of obsolete or unsaleable inventory, but it might also reflect buying raw materials early in anticipation of a price increase or inventory still in the production process.

Receivables collection period: This measures the average number of days it takes customers to pay what they owe. Overall, it indicates how effectively short-term debts are being collected.

Formula:

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

Interpretation: The lower the number of days, the better, because it indicates faster debt collection. A higher number of days (assuming the proportion of cash sales has not increased) indicates receivables are taking longer to pay. You’d typically investigate the terms of trade (credit policy) and whether there are long-outstanding debts that require provisions.

Payables payment period: This measures the average number of days it takes the company to pay its suppliers. It shows how much credit the company is taking. Overall, it reflects the company’s bargaining power with suppliers and its creditworthiness.

Formula:

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

Interpretation: The higher the number of days, the better. An increase in days may indicate greater reliance on payables to finance the business. A decrease in days may indicate the company is taking cash discounts, or it may indicate suppliers are reducing credit terms because of the company’s decreased creditworthiness.

Cash operating cycle: Also referred to as the Cash Conversion Cycle (CCC) or Cash Cycle, this represents the number of days a company takes to turn cash spent on inventory into cash collected from sales. It helps you assess working capital management by tracking the time between paying suppliers and collecting from customers.Formula:

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Illustration: Financial statement analysis

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	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
Accounts 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:
Account 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	3 times
Inventory days	70 days
Receivables collection period	50 days
Payables payment period	60 days
Cash operating cycle	60 days

Required: Calculate the following liquidity 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?

(spoiler)

$Inventory turnover = \frac{Cost of Sales}{Average Inventory}$

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 turnover = \frac{$442 , 300}{$94 , 200} = 4.70 times$

Inventory turns 4.7 times, above the industry’s 3 times. This suggests faster stock movement and more efficient inventory management, which can reduce holding costs and lower the risk of obsolescence.

What is the inventory days?

(spoiler)

$Inventory Days = \frac{Average Inventory}{Cost of Sales} \times 365 days$

You can find inventory on the statement of financial position and cost of sales on the statement of profit or loss.

$Inventory Days = \frac{$94 , 200}{$442 , 300} \times 365 days = 78 days$

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 stock, carrying slow-moving items, or experiencing seasonal effects.

What is the receivables collection period?

(spoiler)

$Receivables collection period = \frac{Account Receivables}{Credit Sales} \times 365 days$

You can find accounts receivable 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.

$Receivables collection period = \frac{$119 , 808}{$935 , 200} \times 365 days = 47 days$

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 bad debt risk.

What is the payables payment period?

(spoiler)

$Payables payment period = \frac{Account payables}{Credit purchases} \times 365 days$

You can find accounts payable on the statement of financial position. Note: Credit purchases is not given explicitly. Cost of sales is given and is used here.

$Payables payment period = \frac{$83 , 300}{$442 , 300} \times 365 days = 69 days$

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?

(spoiler)

$Cash Operating Cycle = Inventory Days + Receivables Collection Period - Payables Payment Period$

Now combine the three working-capital timing measures.

$Cash Operating Cycle = 78 days + 47 days - 69 days = 56 days$

A cash cycle of 56 days, slightly below the 60-day industry benchmark, indicates relatively efficient working capital management. The company converts inventory and receivables into cash a little faster than the industry average.

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Inventory Turnover	4.69 times	3.0 times	+1.69 times	Above industry average - More efficient inventory management
Inventory Days	78 days	70 days	+8 days	Above industry average - Slower inventory movement
Receivables Collection Period	47 days	50 days	-3 days	Below industry average - Faster debt collection
Payables Payment Period	69 days	60 days	+9 days	Above industry average - Longer credit terms utilized
Cash Operating Cycle	56 days	60 days	-4 days	Below industry average - More efficient working capital management

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.