Efficiency ratios measure the effectiveness with which management controls the internal operation of Alpha Ltd. They measure three things, the extent to which assets are used to generate profits, how well stock is managed and the efficiency of creditor control.
- Asset turnover ratio measures Alpha Ltd.’s sales in relation to the assets used to generate these sales.
Formula: Asset Turnover = Sales (Turnover)
= 4.36 times
Alpha Ltd. are using their assets very efficiently to generate sales. They are able to use their assets 4.36 times to generate to generate £1.2million worth of sales. Alpha Ltd. can improve its asset turnover ratio by improving its sales performance and/or disposing any surplus or underutilised assets.
- Stock turnover ratio measures Alpha Ltd.’s success in converting stock into sales.
Formula: Stock turnover ratio = Cost of sales
= 15.5 times a year
Stock turnover ratio = Stock X 365
Cost of sales
= 23.55 days
Alpha Ltd. are able to convert their stock into sales 15.5 times a year or every 23.55 days. This means that Alpha Ltd. are working efficiently; as a food retailer, they are able to sell their stock quickly before perishable items are no longer in date. They can improve their stock turnover ratio by holding lower levels of stock or to achieve higher sales without increasing stock levels.
- Debtors’ collection period calculates the time typically taken by a business to collect the money that it is owned.
Formula: Debtors’ collection period = Debtors X 365
= 1.52 days
Alpha Ltd. are able to gain their cash within 1.52 days which means they are running their business efficiently. They are able to gain from their debtors’ quickly because the majority of their customers pay by cash. Alpha Ltd. can improve their debtors’ collection period by reducing the credit period on offer to customers or by insisting on cash payment.
Profitability ratios assess the amount of gross or net profit made by Alpha Ltd. in relations to Alpha Ltd.’s turnover or the assets or capital available to it.
- Gross profit margin compares the gross profit achieved by Alpha Ltd. with its sales turnover. This ratio calculates the percentage of the selling price of a product that constitutes gross profit.
Formula: Gross profit margin = Gross profit X 100
= 270000 X 100
Alpha Ltd.’s gross profit margin is 22.5% which is very high bearing in mind they are a food retailer. This means for every £1 of sales they make a gross profit of 22.5p. Alpha Ltd. can improve their gross profit margin by increasing their prices although this may result in lower turnover.
- Net profit margin compares the net profit achieved by Alpha Ltd. with its sales turnover. This ratio calculates the percentage of the selling price of a product that constitutes net profit.
Formula: Net profit Margin = Net profit X 100
= 100000 X 100
Alpha Ltd.’s net profit margin is 8.33% which is very high bearing in mind they are a food retailer. This means for every £1 of sales they make a net profit of 8.33p. Alpha Ltd. can improve their net profit margin by increasing selling price or tighter control on costs, particularly indirect costs.
- Return on capital employed (ROCE) is a vital ratio which compares the operating profit earned with the amount of capital employed by Alpha Ltd. This radio allows an assessment to be made of the overall financial performance of Alpha Ltd.
Formula: Return on capital employed (ROCE) = Operating Profit X 100
= 150000 X 100
Alpha Ltd.’s return on capital employed is 54.55% which is exceptional because a typical Ratio is between 20-30%. They have used the money very efficiently to generate profits. To improve their ROCE by increasing its operating profit without raising further capital or by reducing the amount of capital employed, for instance, paying off a long term debt.
In conclusion, Alpha Ltd. have done very well. They are able to settle their debts on time, and also can settle these debts despite selling their stock. In addition, Alpha Ltd. are using their assets very efficiently to generate sales, are able to convert their stock into sales 15.5 times a year or every 23.55 days and are able to gain their cash within 1.52 days from their debtors. Lastly, for every £1 of sales they make a gross profit of 22.5p, every £1 of sales they make a net profit of 8.33p and their return on capital employed is 54.55% which means they have used the money very efficiently to generate profits.
Reference – A2 business studies by Malcom Surridge and Andrew Gillespie
Unit 2 M3