Efficiency ratio analysis

Gearing ratio (%) = non-current liabilities ÷ capital employed × 100, where capital employed = equity + non-current liabilities.

Debtor days is an efficiency ratio measuring the average number of days a business takes to collect payment from its credit customers. It is calculated as trade receivables ÷ revenue × 365. A lower figure means cash is collected faster.

The firm could adopt a Just-In-Time (JIT) stock system, ordering stock only as it is needed. This reduces average inventory held, so stock is sold and replaced more times per year, raising inventory turnover. (Other valid answers: better demand forecasting, or clearing slow-moving lines through discounting.)

Capital employed = 250,000 + 750,000 = $1,000,000. Gearing = 750,000 ÷ 1,000,000 × 100 = 75%. This means 75% of the firm's long-term capital is financed by debt — the firm is very highly geared (well above the 50% threshold). This carries substantial financial risk: interest must be paid regardless of profit, the firm is highly exposed to any rise in interest rates, and lenders will be reluctant to provide further finance. It may need to raise equity to reduce this risk.

Debtor days = 50,000 ÷ 500,000 × 365 = 36.5 ≈ 37 days. Creditor days = 36,000 ÷ 300,000 × 365 = 43.8 ≈ 44 days. On average the firm collects from customers in 37 days but pays suppliers in 44 days. This is favourable for cash flow: it receives cash from customers about a week before it has to pay suppliers, so suppliers effectively help finance its working capital. Management appears reasonably tight on credit control (37 days is fairly prompt). However, if suppliers expect payment sooner than 44 days, the firm risks damaging relationships or losing early-payment discounts, so the position should be monitored.

A highly geared business finances more than half of its capital employed through debt, so it carries large loan balances on which interest must be paid. When interest rates rise, the cost of servicing this debt increases — for variable-rate loans, the interest bill rises immediately, and any new borrowing becomes more expensive. This squeezes net profit and reduces cash available for other uses such as investment or dividends. In a severe case, rising interest costs combined with weak trading could push the firm towards being unable to meet repayments, threatening solvency. The firm may respond by reducing gearing (for example through a rights issue) or by fixing its interest rate. A low-geared firm, by contrast, would be far less affected. The impact therefore depends on how much debt the firm carries, whether its rates are fixed or variable, and how strong its cash flows are.

Raising gearing from 30% to 60% would move the firm from low/neutral gearing to highly geared, using debt to fund expansion. There are strong arguments for it. Debt is generally cheaper than equity (interest is tax-deductible) and issuing shares would dilute the founders' control — a real concern for a young firm whose owners want to retain their vision. Debt also lets the firm act quickly to seize a growth opportunity, and if the expansion succeeds, the extra profit generated on borrowed money would 'gear up' returns to the existing owners without sharing them with new shareholders. For a firm confident of rapid growth, gearing up can accelerate value creation.

However, there are serious risks. At 60% gearing the firm faces large fixed interest payments that must be met whether or not the expansion delivers. Technology markets are volatile and revenues for a fast-growing but perhaps not-yet-profitable firm can be unpredictable, so committing to heavy interest is dangerous — a delay in the expansion paying off could cause a cash crisis. The firm would also become highly exposed to interest-rate rises, and having used up its borrowing capacity, it would find it hard to raise further finance if things went wrong. Ratio analysis has limits too: gearing is historic and says nothing about the quality of the expansion project, management capability or market conditions, so the decision cannot rest on the ratio alone.

On balance, whether the firm SHOULD gear up to 60% depends on the reliability of its forecast cash flows and the economic climate. If the expansion has predictable, contracted revenues and interest rates are low and stable, moderate additional debt is justified. But for a typical volatile tech firm facing rising rates, jumping straight to 60% is probably too aggressive; a smaller increase, or a mix of some debt and some equity, would fund growth while keeping financial risk manageable. The firm should base the decision on cash-flow forecasts and an investment appraisal of the expansion, not on gearing in isolation.

Both changes point to weakening efficiency in managing working capital, and together they could be serious. Inventory turnover falling from 10 to 6 times means stock now sits unsold for about 61 days rather than 37 — more cash is tied up in inventory, storage and obsolescence costs rise, and the fall may signal weaker demand or over-ordering. Debtor days rising from 25 to 45 means customers are taking far longer to pay, so cash is flowing in more slowly; this could reflect weak credit control or customers in financial difficulty. Combined, the two trends lengthen the cash conversion cycle and squeeze liquidity, which for a retailer with thin margins and regular supplier payments could threaten its ability to pay bills — a real short-term danger.

However, the changes must be judged in context before concluding they are critical. The slower stock turnover might be a deliberate strategy — for example holding wider ranges or premium stock that sells more slowly but at higher margin — and longer debtor days might reflect generous credit terms deliberately offered to win customers during expansion. It also matters how the figures compare with INDUSTRY norms and with competitors, and whether they are a one-off or a sustained trend; a single year's dip during, say, a recession may be less alarming than a persistent decline. Ratio analysis alone does not reveal the underlying cause.

Overall, the changes are a warning sign that should be taken seriously because they worsen liquidity, but their seriousness depends on the cause and the firm's cash position. If the firm still has healthy cash reserves and the changes reflect a chosen strategy, they may be acceptable; if they reflect poor management of a firm already short of cash, urgent action — tighter credit control and better stock management — is needed. The priority is to investigate the causes and monitor the trend rather than react to the ratios in isolation.

Gearing and efficiency ratios are valuable tools for a range of stakeholders. Gearing tells lenders and shareholders how much financial risk the firm carries: a bank deciding whether to grant a loan will be reassured by low gearing and wary of a highly geared applicant, while investors use it to judge the risk-return profile of their stake. Efficiency ratios — inventory turnover, debtor days and creditor days — reveal how well managers control working capital, which drives liquidity; suppliers can use creditor days to see how promptly they are likely to be paid, and managers use all three to spot problems such as slow-moving stock or poor credit control early. Because the ratios reduce complex accounts to comparable figures, they allow useful comparison over time (trend analysis) and against competitors (benchmarking), supporting evidence-based decisions.

Yet the ratios have important limitations. They are based on HISTORIC data and may not reflect the firm's current or future position, especially in a fast-changing market. They ignore QUALITATIVE factors that matter greatly to financial health — the quality of management, staff morale, brand strength, market share and the state of the economy. Different firms use different accounting policies (for example depreciation or inventory valuation methods), which distorts comparisons. A single ratio in isolation can also mislead: high gearing is not necessarily bad, and fast inventory turnover is not necessarily good, without industry context. Finally, the ratios can be affected by one-off events or 'window dressing' of the accounts.

Overall, gearing and efficiency ratios are useful but not sufficient. They give stakeholders a quick, comparable snapshot of financial risk and working-capital management and are an excellent starting point, but they should be used ALONGSIDE trend analysis, industry benchmarks and qualitative judgement rather than as a stand-alone verdict on financial health. Their usefulness is greatest when interpreted in context by a stakeholder who understands both the numbers and the business behind them.