Efficiency ratios

A company reports a wonderful quarter: revenue up thirty percent, profit up more, the growth story intact. Buried in the working-capital note, one number has quietly changed - the time it takes to collect money from customers has climbed from forty-five days to seventy-eight. The profit line is shouting good news. That one efficiency number is whispering a question the profit line cannot hear: if sales are really this strong, why is the cash taking so much longer to arrive? illustrative

Efficiency ratios measure something the P&L never shows - how fast a business moves cash through itself. How long goods sit as inventory before they sell. How long customers take to pay. How long the company takes to pay its own suppliers. How many rupees of sales it wrings from each rupee of assets. These are the ratios of motion, and their great virtue is that they turn early: a business getting into trouble usually shows it first in its working capital, because cash stops flowing before earnings stop being reported. Profit can be an opinion; cash is closer to a fact; and efficiency ratios are where you catch the gap between the two opening up. This module is about reading that motion, and above all about reading its trend - because here the direction of travel warns you long before the level does.

Four ratios carry most of the load. Inventory days - how long stock sits before it sells, cash locked in goods. Receivable days - how long customers take to pay after billing, cash locked in other people's hands. Payable days - how long the company takes to pay its own suppliers, other people's cash working for it. And asset turnover - sales divided by assets - the broadest efficiency number, how much revenue the whole asset base generates.

The first three combine into the single most useful working-capital measure, the cash conversion cycle: inventory days plus receivable days minus payable days - the number of days a rupee is tied up between paying for stock and collecting for the sale.

Read the trend, not the level. The level of any efficiency ratio is set mostly by the sector - a jeweller carries months of inventory, a dairy carries days, and neither number means anything without that context. What means something in any business is the direction. Inventory days rising quarter after quarter says goods are selling more slowly - demand softening, or a build-up that will have to be discounted. Receivable days rising says customers are taking longer to pay - a stressed customer base, looser credit to chase sales, or worse. Payable days rising can be strength (better supplier terms) or stress (the firm cannot pay on time); the trend flags it, and you go find out which. Always compare a company with its own past first, and only then with peers.

Two small notes that save confusion. The "turnover" ratios and the "days" ratios are the same fact inverted - inventory that turns over 12 times a year is 30 inventory days; a receivables turnover of 8 is roughly 45 receivable days. Use whichever is clearer. And the cash conversion cycle is the number that decides whether growth is cheap or expensive: a long positive cycle means every rupee of new sales needs fresh working capital behind it, so fast growth drains cash; a negative cycle means customers pay before suppliers are due, so the business grows on its suppliers' money. Watching the cycle lengthen is one of the earliest signs that a growth story is quietly turning into a cash problem - often a full year before the P&L admits anything is wrong.

Efficiency ratios are more sector-bound than almost any other family - the same number is normal in one business, alarming in another, and meaningless in a third. Know the sector's normal before a level can speak.

The thread is that a negative cash conversion cycle is a mark of power for an FMCG firm and near-impossible for an EPC contractor, whose business is structurally cash-hungry - the same cycle length carries opposite messages. For an IT services firm the cycle collapses to a single line, receivable days, because there is no inventory to speak of. For a retailer, inventory turnover is the pulse. A level ripped out of its sector is a temperature with no scale; a trend is a story you can act on.

A composite auto-components supplier illustrative reports a strong year - revenue up 24%, profit up 28% - and the market is pleased. Look at the working capital underneath, and a different story shows.

Walk the three days. Inventory days have risen from 40 to 58: more stock relative to sales, which could be a deliberate build ahead of a model launch, or goods moving more slowly than they used to. Receivable days have risen from 52 to 81: customers taking a month longer to pay, a move revenue growth alone cannot explain. Payable days have crept from 45 to 60, cushioning the cash impact a little - but note why, because stretching suppliers can be strength or scramble. Put them together and the cash conversion cycle has stretched from 47 days to 79. Every rupee of sales is now trapped a full month longer than it was.

Now the consequence. Profit grew 28%, but with the cycle lengthening this much, almost none of that profit shows up as cash - it has flowed straight into a swelling pile of inventory and receivables. So the cross-check follows immediately: compare operating cash flow with reported profit, and you would expect cash flow lagging badly, because working capital has swallowed the earnings. The ratios have done their job - they flagged, a year before it shows anywhere else, that this "strong year" grew profit and receivables together, and the quality of that growth now hangs on whether those receivables are real and collectible or the residue of sales pushed to customers who cannot pay. Read the working-capital trend as a lie-detector on the profit line.

Set the three levers - how long stock sits, how long customers take to pay, how long you take to pay suppliers - and watch the days of cash tied up swing from a drain into a source. Push payable days past the sum of inventory and receivable days and the cycle turns negative: the business is now funded by its suppliers, and every rupee of growth needs no working capital of its own.

An efficiency ratio tells you that something moved, never why. Receivable days rising could be a stressed customer base, deliberately looser credit to win share, a mix shift toward slower-paying customers, or outright channel stuffing - and the number is identical in every case. The ratio raises the flag and points at the working capital; the reason is a separate search through the notes, the customer concentration, and the management commentary. Reading the move as automatically sinister is as wrong as ignoring it - the move is a question, and the answer is elsewhere.

Nor can these ratios judge the quality of what is on the balance sheet. Inventory days assume the inventory is saleable; some may be obsolete stock heading for a write-off. Receivable days assume the receivables are collectible; some may be from customers who will never pay. The days count the size of the pile, not how much of it is good - which is why a stable inventory number can hide a growing lump of dead stock, and a flattering receivables number can hide a hardening core of bad debt, and why the notes on provisioning and ageing matter as much as the ratio.

And efficiency ratios are noisy over short periods and around seasonal peaks. A quarter-end that falls just after a big shipment can make receivable days spike for reasons that reverse next month; a seasonal business will show inventory building ahead of its selling season every year, which is normal. Read them over several periods and against the same quarter a year earlier - never against the quarter just gone: a single period's swing is mostly noise, and the signal lives in the multi-year direction.

When working capital deteriorates alongside good headline numbers, a sharp analyst asks management to explain the cash, not just the profit: "Receivable days went from 52 to 81 this year - customer mix, extended credit, or collection issues? And how much of the profit growth actually converted to operating cash?"

A good answer separates the benign part from the worrying part and puts a number on the conversion:

"Fair to flag it. About half the increase is a genuine mix shift - we won a large OEM on 90-day terms, standard for that channel. The other half is slower collection from two smaller customers we're watching, and we've provided against one. Operating cash flow was about 70% of profit this year, down from 95%, mostly because of this."

An evasive one waves it away: "Working capital was a bit elevated due to strong growth and some timing at the quarter-end, but it's well within our normal range and we're comfortable with the quality of our book." Notice the moves - "strong growth" cannot explain days rising faster than sales; "timing at quarter-end" is the universal excuse for a working-capital build; and "comfortable with the quality of our book" asserts collectibility without a single number on provisions or cash conversion. The follow-up that settles it is the one nobody wants to answer: what was operating cash flow as a percentage of profit, and what is the ageing of receivables over 90 days? If the room accepts "elevated due to growth and timing" without those figures, either the cash conversion was poor or the receivables are ageing and nobody wants to say by how much. That is the setup this module exists to catch.