Financial ratios are essential tools that help businesses assess their performance, efficiency, and financial stability. By analysing key ratios, managers can make informed decisions about liquidity, profitability, and financial risk, ensuring the long-term success of a company.
In this activity, you will explore four crucial financial ratios used in business management:
- Stock Turnover – Measures how efficiently a company sells and replaces its inventory.
- Debtor Days – Calculates the average time taken to collect payments from customers.
- Creditor Days – Determines how long a business takes to pay suppliers.
- Gearing Ratio – Assesses how much of a company’s long-term capital comes from debt.
Through a business scenario featuring Lumberjack Larry’s Legendary Logs, you will calculate, analyse, and interpret these ratios. This will help you develop a deeper understanding of business finance and how companies balance risk, efficiency, and financial sustainability.
By the end of this activity, you will not only master key financial calculations but also learn how to interpret and apply them in a business context—essential skills for business management success!
Stock Turnover: Understanding and Practice
Introduction to Stock Turnover
Stock turnover measures how efficiently a business converts stock into sales. It shows how often a company sells and replaces its stock within a given period, helping businesses optimize inventory levels.
Additionally, stock turnover can be used to calculate the average number of days it takes to sell stock, giving businesses insight into how long inventory sits before being sold.
Formulas:
Stock Turnover Ratio (times per year)
Where:
- Cost of Sales (from the Profit and Loss statement) represents total production costs.
- Average Stock is calculated as:
Stock Turnover (Number of Days to Sell Stock)
A higher turnover suggests efficient stock management, while a lower turnover may indicate excessive stock levels or slow sales.
Case Study: Lumberjack Larry’s Legendary Logs 🌲
Lumberjack Larry’s Legendary Logs is a highly regarded timber mill, famous for its premium quality wood and Larry’s wild storytelling while chopping logs. The company operates a large warehouse storing raw timber before it is processed into planks and sold to carpenters and furniture makers.
Larry is concerned about excess stock sitting in storage and wants to evaluate how efficiently the business is using its timber supplies.
In 2023, the company’s financials were:
- Opening Stock: $4,500,000
- Closing Stock: $3,800,000
- Cost of Sales: $22,000,000
Task for Students
Q1. Calculate the stock turnover ratio of Lumberjack Larry’s Legendary Logs for 2023. Show all of your workings.
Q2. Calculate the average number of days it takes to sell off stock. Show all of your workings.
Q3. Interpret the results from Q1 and Q2. What could we learn from them about the company’s inventory management?
Q4. Explain what a low/high stock turnover ratio can reveal to us about how a company is operating.
Debtor Days: Understanding and Practice
Introduction to Debtor Days
Debtor days measure how long, on average, a business takes to collect payments from customers who bought goods on credit. This is crucial for managing cash flow, as delayed payments can lead to liquidity
problems.
A business might offer credit terms (e.g., 30 or 60 days)
to attract customers, but if debtor days are too high, it may struggle to pay its own bills.
Formula:
Where:
- Debtors (accounts receivable) = The amount customers owe the business.
- Total Sales Revenue = Total income from sales (credit sales if available, otherwise total revenue).
A lower debtor days figure means customers are paying quickly, while a higher figure could indicate potential cash flow issues.
Case Study: Lumberjack Larry’s Legendary Logs 🌲
Lumberjack Larry’s Legendary Logs supplies high-quality timber to furniture makers and construction companies. Because large orders can be expensive, Larry allows customers to pay on credit, offering 60-day payment terms to attract buyers.
However, Larry is concerned that some customers take too long to pay, which affects the company’s cash flow. To investigate, he calculates his debtor days ratio.
In 2023, the company’s financials were:
- Debtors (Accounts Receivable): $1,200,000
- Total Sales Revenue: $8,500,000
Task for Students
Q1. Calculate the debtor days ratio for Lumberjack Larry’s Legendary Logs for 2023. Show all of your workings.
Q2. Interpret the result from Q1. What does this tell us about how quickly the company collects payments? Does it meet Larry’s expectations of 60 days?
Q3. Explain what a high or low debtor days ratio can reveal about how a company is operating.
Creditor Days: Understanding and Practice
Introduction to Creditor Days
Creditor days measure the average time a business takes to pay its suppliers and other creditors. Managing this effectively can help a business avoid liquidity problems, ensuring it has enough cash to cover operational expenses.
If a business delays payments to suppliers, it retains cash longer, improving short-term liquidity. However, paying too late may damage relationships with suppliers or result in penalties.
Formula:
Where:
- Creditors (Accounts Payable) = The amount the business owes to suppliers.
- Cost of Sales = Used as an approximation of total credit purchases.
A higher creditor days figure means the business is taking longer to pay suppliers, improving liquidity but potentially harming supplier relationships. A lower figure means suppliers are paid quickly, but this could strain cash flow.
Case Study: Lumberjack Larry’s Legendary Logs 🌲
Lumberjack Larry’s Legendary Logs relies on suppliers for raw timber, sawmill maintenance, and transportation services. Larry prefers to delay payments as long as possible to maintain cash flow, but he must also keep suppliers happy.
To assess his payment efficiency, Larry calculates his creditor days ratio.
In 2023, the company’s financials were:
- Creditors (Accounts Payable): $950,000
- Cost of Sales: $7,500,000
Task for Students
Q1. Calculate the creditor days ratio for Lumberjack Larry’s Legendary Logs for 2023. Show all of your workings.
Q2. Interpret the result from Q1. What does this tell us about how quickly the company pays its suppliers?
Q3. Compare Lumberjack Larry’s creditor days and debtor days. What does this tell us about the company’s liquidity position?
Q4. Explain what a high or low creditor days ratio can reveal about how a company is operating.
Gearing Ratio: Understanding and Practice
Introduction to Gearing Ratio
The gearing ratio measures how much of a company’s long-term capital is financed by debt (non-current liabilities) compared to equity (owner investment).
It is a key financial metric that helps determine the financial risk of a business.
Why is this important?
- A business with high gearing (more debt) relies heavily on borrowed money to finance its operations, making it vulnerable to interest rate increases and economic downturns.
- A business with low gearing (more equity) is less risky but may grow more slowly if it avoids loans that could fund expansion.
Formula:
Where:
- Non-Current Liabilities = Long-term debt (e.g., bank loans, bonds).
- Capital Employed = Total long-term capital, calculated as:
The result is expressed as a percentage, showing how much of the company’s funding comes from borrowed money.
What Do the Results Mean?
- High Gearing (Above 50%) → More than half of the company’s funding comes from loans, meaning higher financial risk.
- Low Gearing (Below 50%) → The company relies more on equity and has lower financial risk but may miss out on growth opportunities from borrowing.
Case Study: Lumberjack Larry’s Legendary Logs 🌲
Lumberjack Larry’s Legendary Logs is expanding operations by building a second sawmill. To finance this, Larry took out a large bank loan, increasing the company’s long-term debt.
Larry wants to calculate his gearing ratio to assess the company’s financial risk.
In 2023, the company’s financials were:
- Non-Current Liabilities (Long-Term Loans): $2,300,000
- Equity (Owner’s Investment): $3,700,000
Task for Students
Q1. Calculate the gearing ratio for Lumberjack Larry’s Legendary Logs for 2023. Show all of your workings.
Q2. Interpret the result from Q1. What does this tell us about how the business is financed?
Q3. Explain what it means for a business to be highly geared or low geared. What are the risks and advantages of each?
Q4. Suggest two ways that Lumberjack Larry’s Legendary Logs could reduce its gearing ratio.
Extension Activity: Financial Ratio Analysis & Business Strategy
Lumberjack Larry is considering two major business decisions:
- Expanding into a new product line – Selling custom-designed wooden furniture, which requires significant investment in equipment and raw materials.
- Improving cash flow – By renegotiating supplier contracts to extend payment terms while offering discounts to customers who pay early.
Task for Students:
Q1. Based on Larry’s current stock turnover, debtor days, and creditor days, discuss whether his business can handle the extra inventory required for the new furniture line.
Q2. How might the expansion affect his gearing ratio if he takes out a loan to fund new equipment? Would this be a risk for the business?
Q3. If Larry renegotiates with suppliers to increase his creditor days, what impact could this have on his debtor days and overall liquidity?
Q4. Based on everything you’ve learned, recommend a financial strategy for Lumberjack Larry’s Legendary Logs. Should he expand? Should he prioritize improving liquidity? Justify your answer using the ratios.
