Skip to main content
ExamExplained

Efficiency and Financial Stability Ratios (SACE Stage 2 Accounting)

Syllabus dot point

“Calculate and interpret efficiency and financial stability ratios to evaluate asset management and gearing”

6 min read

Quick answer

Efficiency ratios show how well a business uses its assets: inventory turnover (how fast stock sells) and the debtors collection period (how quickly customers pay). Financial stability ratios show long-term solvency: the debt ratio and equity ratio measure how much of the business is funded by borrowing versus the owner. Together they extend profitability and liquidity analysis.

Jump to a section
  1. What this dot point is asking
  2. Efficiency ratios
  3. Financial stability ratios
  4. Reading them together
  5. Limitations of ratio analysis
  6. Exam-style questions

What this dot point is asking

You need to calculate the standard efficiency and stability ratios, state their formulae, and interpret what they reveal about how a business is run and funded.

Efficiency ratios

Efficiency (activity) ratios measure how productively assets are managed.

Efficiency ratios

Inventory turnover (times)=Cost of goods soldAverage inventory\text{Inventory turnover (times)} = \frac{\text{Cost of goods sold}}{\text{Average inventory}}

Debtors collection period (days)=Average debtorsNet credit sales×365\text{Debtors collection period (days)} = \frac{\text{Average debtors}}{\text{Net credit sales}} \times 365

A higher inventory turnover means stock sells quickly, freeing cash and reducing the risk of obsolescence. A shorter debtors collection period means customers pay faster, improving cash flow.

Financial stability ratios

Financial stability (solvency) ratios measure the ability to meet long-term obligations and the reliance on borrowed funds.

Financial stability ratios

Debt ratio=Total liabilitiesTotal assets×100\text{Debt ratio} = \frac{\text{Total liabilities}}{\text{Total assets}} \times 100

Equity ratio=Owner’s equityTotal assets×100\text{Equity ratio} = \frac{\text{Owner's equity}}{\text{Total assets}} \times 100

A high debt ratio means the business is heavily geared, which raises returns when trading is good but increases risk if profits fall, because interest must still be paid. The debt ratio and equity ratio together add to 100 percent of total assets.

Calculating and reading the ratios

Figures for the year

Cost of goods sold $360,000; average inventory $60,000; average debtors $40,000; net credit sales $500,000; total assets $800,000; total liabilities $320,000; owner's equity $480,000.

Inventory turnover =360,00060,000=6= \dfrac{360{,}000}{60{,}000} = 6 times a year (stock turns over roughly every two months).

Debtors collection period =40,000500,000×365=29.2= \dfrac{40{,}000}{500{,}000} \times 365 = 29.2 days, so customers pay in about a month.

Debt ratio =320,000800,000×100=40%= \dfrac{320{,}000}{800{,}000} \times 100 = 40\%.

Equity ratio =480,000800,000×100=60%= \dfrac{480{,}000}{800{,}000} \times 100 = 60\%.

Interpretation: stock and debtors are managed well, and at 40 percent debt the business is moderately geared with the owner funding the majority. The two funding ratios sum to 100 percent, confirming the calculation.

Reading them together

Efficiency and stability ratios complete the picture started by profitability and liquidity. Fast inventory turnover and quick debtor collection support liquidity. A low debt ratio reduces risk but may mean the owner is not using borrowing to grow. As always, a ratio is judged against trend and industry context, not a single benchmark.

Gearing creates a trade-off the owner must weigh. Borrowing magnifies the return on owner's equity when the business earns more on the borrowed funds than the interest costs, but it magnifies losses just as sharply when trading turns down, because interest is a fixed commitment. A retailer with rapid inventory turnover can carry more debt safely than one holding slow-moving stock, since its assets convert to cash quickly. This is why the efficiency ratios and the stability ratios are read together: the speed at which assets become cash partly determines how much debt the business can prudently support.

Common error

Confusing turnover times with days. Inventory turnover is a number of times per year, while the debtors collection period is a number of days. A common slip is to leave off the multiply-by-365 in the collection period, producing a meaningless fraction instead of a number of days.

Limitations of ratio analysis

SACE evaluation questions reward you for recognising what ratios cannot tell you. Ratios are based on historical, end-of-period figures, so they describe the past rather than guaranteeing the future, and a balance-day snapshot of inventory or debtors may not represent the typical level across the year. Ratios also ignore qualitative factors such as management quality, staff morale, the strength of the brand and the competitive environment, none of which appear in the statements. Comparisons can mislead if two businesses use different accounting policies (for example different depreciation methods), or if inflation distorts figures measured at historical cost. The strongest answers therefore use efficiency and stability ratios as a starting point for questions, then qualify any judgement with trend data, an industry benchmark, and the non-financial context.

Exam-style questions

Questions in the style of SACE Board exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.

2024 SACE Stage 2-style4 marks
Calculate the following forecast ratios for Kyandi's Kreations as at 30 June 2025: the debt ratio, the debt to equity ratio, and the working capital ratio. (Total assets $188,000, total liabilities $108,000, net equity $80,000, current assets $68,000, current liabilities $18,000.)
Show worked answer →

Use the SACE formulas, showing working for each.

  1. Debt ratio = total liabilities / total assets = 108,000 / 188,000 = 57.4%. More than half the assets are financed by debt.

  2. Debt to equity = total liabilities / owner's equity = 108,000 / 80,000 = 135%. The business owes $1.35 for every $1 of equity, so it is fairly highly geared.

  3. Working capital (current ratio) = current assets / current liabilities = 68,000 / 18,000 = 3.78 : 1. There are $3.78 of current assets for every $1 of current liabilities, indicating strong short-term liquidity.

Markers reward the correct formula, correct figures and the right unit for each (percentage, percentage, and a ratio). State the debt ratio and debt to equity as percentages and the working capital ratio as a ratio.

2023 SACE Stage 2-style2 marks
Identify a solvency ratio that a bank would use to determine whether a business is eligible for a loan, and calculate this ratio for Lakeland Sports for 2023. (Total liabilities $391,200; total assets $648,000; equity $256,800; profit plus interest available.)
Show worked answer →

A bank assessing long-term solvency would use the debt ratio (or debt to equity, or times interest earned).

Debt ratio = total liabilities / total assets = 391,200 / 648,000 = 60.4%.

This means about 60% of the assets are funded by debt. A bank reads a high debt ratio as higher risk, because the business is heavily reliant on borrowed funds and has less of an asset buffer if it cannot repay. The result here would make a bank cautious about extending further finance.

Markers reward naming a genuine solvency (long-term stability) ratio, the correct formula and figures, an answer as a percentage, and a brief interpretation linked to lending risk.

2021 SACE Stage 2-style2 marks
Calculate the 2021 debt ratio for Enduring Couture, then explain how this ratio could be used by an internal stakeholder.
Show worked answer →

Debt ratio = total liabilities / total assets, expressed as a percentage. Substitute the business's totals and show the working to reach the percentage.

Use by an internal stakeholder: the owner (an internal user) uses the debt ratio to judge how reliant the business is on borrowed funds and whether it is over-geared. A rising debt ratio warns the owner that interest commitments and repayment risk are growing, which may influence decisions to repay debt, slow expansion, or inject more capital rather than borrow further.

Markers reward the correct formula and percentage, plus an explanation that names the owner as the internal user and links the ratio to a real management decision about gearing or financing.

Practise this

Sources & how we know this

Based on the official SACE Board subject outline. Not yet individually reviewed by a person; always check SACE Board and your school's materials for current rules.

ExamExplained