Key Takeaways
- ✓ Efficiency ratios measure working capital management: inventory turnover shows how often stock is sold and replaced; the receivables collection period shows average customer payment time; the payables payment period shows how long the business takes to pay suppliers.
- ✓ Earnings per share (profit after tax divided by number of ordinary shares) represents the profit attributable to each share and is a key metric for investors comparing profitability across companies of different sizes.
- ✓ Ratio analysis has significant limitations: it uses historical data, is affected by different accounting policies between companies, and ignores non-financial value drivers including staff quality, brand strength, customer satisfaction and management capability.
Full Transcript
What are efficiency ratios and how are they calculated?
Alex: Welcome to the Leadership and Management podcast. I'm Alex, and today Sam and I are extending the ratio analysis conversation from our last episode. We covered profitability and liquidity ratios last time. Today it's efficiency, investment ratios, and crucially, what ratios cannot tell you.
Sam: That last part is important. A lot of the critical thinking marks in this subject come from understanding the limits of the tools you're using, not just from applying them correctly.
What is the cash conversion cycle and why does it matter?
Alex: Let's start with efficiency ratios. These measure how well a business manages its assets in the day-to-day operating cycle.
Sam: The operating cycle is the flow of cash through the business: you buy stock, you sell it, you collect the cash from customers, and you pay your suppliers. Efficiency ratios measure how long each stage takes. Inventory days tells you how long stock sits in the business before being sold. If a supermarket like Tesco has inventory days of around 20, that means fresh food is turning over fast, which you'd expect. A furniture retailer might have 90 days or more. Receivable days shows how long customers take to pay. Payable days shows how long you're taking to pay suppliers.
Alex: And these three combine into something called the cash conversion cycle.
How do investment ratios help shareholders evaluate a company?
Sam: Exactly. It's inventory days plus receivable days minus payable days. The shorter the cycle, the faster cash flows back into the business. Some very efficient retailers actually achieve a negative cash conversion cycle, meaning they collect cash from customers before they have to pay their suppliers. That's a very powerful commercial position to be in.
Alex: And there's the question of window dressing.
Sam: Window dressing is where a business temporarily improves its position at the balance sheet date to make the ratios look better. Collecting debts aggressively in the final week of the year to boost the cash balance, for example, then extending credit again in the first week of the new year. The ratios look healthier than the underlying reality. And then there are factors that ratios simply don't capture: the quality of management, staff morale, brand reputation, the competitive landscape, or the innovation pipeline. A business with declining ratios might be investing heavily in transformation that will pay off in three years.
What is window dressing in financial reporting?
Alex: So the sophisticated approach to ratio analysis is always to ask: what does this tell me, and equally importantly, what does it not tell me?
Sam: That's the distinction-level thinking. Ratios are a diagnostic tool, not a verdict. They tell you where to focus your inquiry, what questions to ask, which areas need investigation. But they don't replace judgement, and they don't give you the full picture on their own.
What are the limitations of financial ratio analysis?
Alex: A question to consider: if you were advising a bank on whether to lend money to a business, and you had a full set of ratios in front of you, what non-financial information would you still want before making your decision? And how much weight would you give each source of information?