Q.Identify and state the significance of any two ratios that are calculated to measure the efficiency of operations of business based on effective utilisation of resources.
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Start your 14-day free trial to unlock the full solution →The two ratios that measure the efficiency of operations based on effective utilisation of resources are Inventory Turnover Ratio and Trade Receivables Turnover Ratio. These ratios show how quickly a business converts its inventory into sales and collects cash from credit customers, respectively.
Concept and Accounting Treatment
Efficiency ratios, also called activity or turnover ratios, are a subset of Ratio Analysis used to evaluate how well a business uses its assets and resources to generate revenue. They are not journal entries or ledger accounts — they are analytical tools computed from the financial statements (Trading and Profit & Loss Account, Balance Sheet). The underlying accounting principle is the matching concept: costs (resources used) are matched with revenues (output generated) over a period. A higher turnover ratio generally indicates better efficiency, but it must be compared with industry standards or past trends.
The two key efficiency ratios are:
- Inventory Turnover Ratio – measures how many times inventory is sold and replaced during a period.
- Trade Receivables Turnover Ratio – measures how efficiently credit sales are collected.
A common mistake is to use the average of opening and closing balances for inventory or receivables, but if only one figure is given (e.g., closing inventory), use that. Also, for Trade Receivables Turnover, always use Net Credit Sales (not total sales) — if credit sales are not separately given, assume all sales are credit sales.
Solution: The Two Ratios
1. Inventory Turnover Ratio
Formula:
Inventory Turnover Ratio = Cost of Revenue from Operations (Cost of Goods Sold) / Average Inventory
Significance:
- It indicates how efficiently inventory is managed. A high ratio means goods are sold quickly, reducing holding costs and risk of obsolescence. A low ratio suggests overstocking or slow-moving inventory.
- It helps in assessing liquidity of inventory and effectiveness of purchasing and sales policies.
Example Calculation (hypothetical):
- Cost of Goods Sold = ₹5,00,000
- Opening Inventory = ₹80,000, Closing Inventory = ₹1,20,000
- Average Inventory = (₹80,000 + ₹1,20,000) / 2 = ₹1,00,000
- Inventory Turnover Ratio = ₹5,00,000 / ₹1,00,000 = 5 times
If only closing inventory is given, use that as the denominator. The ratio is expressed as "times" — it has no unit.
2. Trade Receivables Turnover Ratio
Formula:
Trade Receivables Turnover Ratio = Net Credit Sales / Average Trade Receivables
Significance:
- It measures how quickly a company collects cash from its credit customers. A high ratio indicates prompt collection and efficient credit management. A low ratio may signal poor collection efforts or lenient credit terms.
- It is crucial for assessing the quality of receivables and the company's short-term liquidity position.
Example Calculation (hypothetical): …
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