Performance ratios measure how well a business is using its resources to generate income. Good management of stock and reducing time it takes to complete processes can improve the efficiency of a business. 

Key Performance Ratios include:

• Trade receivable Days

• Trade Payable Days

• Inventory Turnover Ratio

Extracts from the income statements and statements of financial position for The Coffee Hub

Trade Receivable Days

Trade receivable days measure how quickly customers settle their bills. Longer trade receivable days imply a business needs better systems to chase payments. It is calculated using the formula

Trade receivable days = (trade receivable/credit sales) × 365

For the Coffee Hub in 2023, trade receivable days = (7,000 / 70,000) x 365 = 36.5 days. This means they waited an average 36.5 days for their customers to settle their invoices.

From 2019 to 2023, trade receivable days for The Coffee Hub has gradually increased from 7 days to 37 days. This means they are taking longer to collect payments from their customers which could indicate issues with their systems to collect payments. However, it could also be due to managers giving their customers longer payment terms as a strategy to enhance relationships. 

Trade receivables (debtors) are the money owed to a business by its customers for goods or services that have been delivered but not yet paid for. This item is recorded under current assets on the balance sheet as the business expects to receive this payment soon.

Credit sales are sales made during a specified period but the customer is yet to pay. These are recorded on the income statement as revenue generated from the sales of goods and services. A typical credit period given to customers is from 30 - 60 days.

Lower trade receivable days are more desirable as it means a business is more efficient at collecting payments improving cash flow. Higher trade receivable days indicate potential issues with customer payments and may lead to liquidity concerns.

However, desirable trade receivable days can vary from industry to industry. For example, in construction, trade receivable days are much longer as debtors wait much longer for their customers to pay due to the project-based nature of the work. Hospitality outlets such as the coffee hub would tend to expect much shorter trade receivable days as the majority of their customers would pay in cash and any credit sales would be expected to be settled quickly.

Trade Payable Days

Trade payable days measure how quickly a business pays its invoices. If they take longer to pay their invoices, their liquidity increases but they may risk their relationships with suppliers. It is calculated using the formula

trade payable days = (trade payables/credit purchases) × 365

For The Coffee Hub in 2023, trade payable days = (34,000 / 274,000) x 365 = 45 days. This means that it took them an average of 45 days from receiving deliveries to pay their supplier invoices.

From 2019 to 2023, trade payable days for The Coffee Hub have increased from 34 days to 45 days with fluctuations of 72 days in 2021 and 59 days in 2022. This means they are taking longer to pay their suppliers which could indicate issues with their systems to make payments or lack cash available. In 2021, their trade payable days was 72 days which is outside of the standard 30 - 60 day period putting them at risk of damaging relationships with suppliers.

Trade payables (creditors) are the money a business owes its suppliers for goods or services received but not yet paid for. This item is recorded under current liabilities on the balance sheet as the business is expected to make this payment soon.

Credit purchases are the purchases a business has made from their supplier during a specified time period with an agreement to pay later. These are recorded on the income statement as part of the cost of goods sold and contribute to the calculation of gross profit.

Longer trade payable days generally indicate poor financial management as businesses may be struggling to pay their bills on time. Late payments can lead to suppliers taking actions such as refusing future deliveries, late payment charges or legal action if issues persist. 

Shorter trade payable days generally indicate good financial management as the business is conducting the processes to settle their bills quickly. This can lead to good relationships with suppliers which can come with benefits such as early payment discounts. 

However, early payment to suppliers limits the cash available in the business. This may cause cash flow problems if the business is waiting for their own debtors to pay. The optimal trade payable days depends on the industry and agreements made with individual suppliers.

Inventory Turnover Ratio

The inventory turnover ratio measures how long the average item of stock is held by a business before it is sold. Longer times may result in high storage costs and obsolete stock and could be the result of overproduction or poor marketing. It is calculated using this formula

inventory turnover ratio = (average inventory/cost of sales) × 365

For The Coffee Hub in 2023, inventory turnover ratio = (30,000 / 385,000) x 365 = 28 days. This means that they held onto their stock for an average of 28 days before selling it.

From 2019 - 2023, the inventory turnover ratio for The Coffee Hub has gradually decreased from 65 days to 28 days. This means that they are not holding onto their stock for as long over time. This could indicate that they have improved their marketing to increase sales or they are reducing the stock they hold. Lower inventory turnover ratios are important for businesses like The Coffee Hub because inventory such as coffee beans and milk are perishable and may need to be thrown away if they are held onto for too long.

Average Inventory is the average amount of stock (finished goods or raw materials) available for sale during a specified time period. It is calculated using this formula

Average inventory = (opening inventory + closing inventory) / 2

However, where opening and closing inventory figures are unavailable, you can use the inventory figure from the current liabilities on the statement of financial position.

Effective inventory management is important to business performance. Holding too much stock can increase costs related to storage, increase the risk of obsolescence and can lead to cash flow issues as money is tied up in that stock until it sells. However, not having enough inventory can lead to a business not being able to meet customer demand.

Shorter inventory turnover ratios mean that a business is very efficient in selling their stock. This may indicate effective sales strategies such as a powerful marketing campaign or good pricing strategies. It may also indicate that the business is good at managing their inventory, e.g. not holding more stock than they know they can sell shortly.

Longer inventory turnover ratios mean that a business is less efficient in selling their stock. This could indicate that products are less popular than expected which could in turn indicate issues with the marketing mix. It could also indicate that a business is overstocking and needs to be more effective in predicting future sales.

However, desirable inventory turnover ratios vary from industry to industry. More perishable goods (e.g. flowers) require a shorter inventory turnover than more durable goods (e.g. washing machines). Industries where trends change quickly (e.g. fashion) require a shorter turnover ratio than those where trends change more slowly (e.g. board games).

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