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: