Gearing and Efficiency Ratios

Building on the profitability and liquidity ratios covered in the previous lesson, this lesson examines gearing and efficiency ratios. These ratios reveal how a business finances its operations and how effectively it manages key working capital components. Together, they give a more complete picture of financial health and strategic risk, as required by AQA specification topic 3.7.2.

---

Gearing Ratio

Gearing Ratio = (Non-current Liabilities ÷ Capital Employed) × 100

Capital employed = Total equity + Non-current liabilities

Gearing measures the proportion of a business's long-term finance that comes from debt (non-current liabilities such as bank loans, debentures and bonds) rather than equity (shareholders' funds). It is a measure of financial risk.

Company	Non-current Liabilities (£m)	Total Equity (£m)	Capital Employed (£m)	Gearing
Firm A	20	80	100	20%
Firm B	60	40	100	60%
Firm C	85	15	100	85%

Interpreting Gearing

• Below 25% — Low gearing. The business is primarily equity-financed. Lower financial risk, but potentially missing out on the tax advantages of debt.
• 25–50% — Moderate gearing. A balanced mix of debt and equity is typical for established businesses.
• Above 50% — High gearing. The business relies heavily on borrowed funds. This increases financial risk because interest payments must be met regardless of profit levels.

Why Gearing Matters

High gearing amplifies both gains and losses — a concept known as financial leverage:

• In good times, a highly geared firm can generate exceptional returns for shareholders because profits are spread across a smaller equity base after interest is paid.
• In bad times, fixed interest obligations can erode profits rapidly or even cause insolvency. The business has less flexibility to cut costs because interest payments are contractual.

Real-World Example: Debenhams

Debenhams entered administration in 2019 carrying approximately £560 million in debt. The high gearing left the company unable to invest in store refurbishments or its online platform while simultaneously servicing debt. When revenues declined, the fixed interest burden became unsustainable. This illustrates how excessive gearing can constrain strategic options and accelerate decline.

Factors Influencing Acceptable Gearing

Factor	Effect on Acceptable Gearing
Stability of cash flows	Businesses with predictable revenues (e.g., utilities) can sustain higher gearing
Interest rates	Low interest rates make debt cheaper, encouraging higher gearing
Asset base	Asset-rich firms can offer collateral, making borrowing easier and safer
Industry norms	Capital-intensive industries (airlines, property) typically operate with higher gearing
Growth stage	Start-ups may have high gearing due to limited retained profits; mature firms usually deleverage

Exam Tip: When discussing gearing, always link it to financial risk and strategic flexibility. A highly geared firm may be unable to invest in growth opportunities because its cash is absorbed by debt repayments. However, avoid the simplistic conclusion that "high gearing is bad" — in a low-interest-rate environment with stable revenues, gearing can enhance shareholder returns. The key is whether the returns generated exceed the cost of debt.

---

Efficiency Ratios

Efficiency ratios (also called activity ratios) measure how well a business manages its working capital — the day-to-day flow of cash through inventories, receivables and payables. Poor working capital management is one of the most common causes of business failure.

Payables Days (Creditor Days)

Payables Days = (Trade Payables ÷ Cost of Sales) × 365

This measures the average number of days it takes a business to pay its suppliers. A longer payables period means the business holds onto cash for longer — improving its own cash flow at the expense of its suppliers.

Scenario	Trade Payables (£m)	Cost of Sales (£m)	Payables Days
Year 1	12	146	30 days
Year 2	18	150	44 days

An increase from 30 to 44 days could indicate:

• A deliberate strategy to improve cash flow by negotiating longer payment terms with suppliers
• Cash flow difficulties forcing the business to delay payments
• A change in supplier relationships — but extended delays can damage goodwill and lead to suppliers refusing credit or prioritising other customers

Receivables Days (Debtor Days)