In simple terms
A friendly intro before the formal notes — no formulas yet.
The dashboard behind the profit figure
Debt and efficiency ratios are the warning lights on a business's dashboard. Gearing tells you how much of the engine is running on borrowed fuel — useful for speed, dangerous if the price of fuel (interest) jumps. The efficiency ratios are the speedometers of the working-capital cycle: how fast stock sells, how fast customers pay you, and how slowly you can pay your suppliers. A business can look profitable on the surface and still stall if these gauges are in the red.
Imagine you run a market stall selling trainers. Gearing is the share of your stall that you set up with a loan from the bank rather than your own savings — borrow a lot and you can stock more shelves, but every month the interest is due whether or not you sell a single pair. Stock turnover is how many times you clear and refill the shelves in a year; debtor days is how long a customer who bought 'on tick' takes to actually hand over the cash; and creditor days is how long your supplier lets you wait before paying for the trainers. You stay liquid by selling fast, collecting from customers quickly, and paying your supplier a little more slowly.
- 1
Pick the correct formula for the ratio the question asks for — gearing uses capital employed; stock turnover and creditor days use cost of goods sold; debtor days uses sales revenue.
- 2
Pull the exact figures from the case study's financial statements and substitute them in, showing your working.
- 3
Calculate accurately and attach the correct unit — a percentage for gearing, 'times' or 'days' for the efficiency ratios.
- 4
Interpret the result in context — compare it to previous years, competitors or industry norms — and, if asked, suggest a realistic way to improve it.
Explore the concept
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Key formulas
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$Gearing Ratio (%) = \frac{\text{Long-term liabilities}}{\text{Capital employed}} \times 100$
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Full topic notes
Formal explanation with the rigour you need for the exam.
The gearing ratio: how a business is financed
The gearing ratio measures the proportion of a firm's capital employed that comes from long-term debt rather than from the owners' equity. It answers a single, important question: is this business financed mainly by money it owes, or by money it owns? A highly geared firm carries large fixed interest payments and repayment obligations that fall due whether or not it is trading well, which makes it more vulnerable to rising interest rates and economic downturns. A low-geared firm is safer but may be leaving growth on the table by not using cheap debt. Gearing is therefore a measure of long-term financial risk, and how a business is financed.
Gearing Ratio (%) =
Capital employed = long-term (non-current) liabilities + total equity (share capital + retained earnings). It is the total long-term funding the business is using.
Low gearing (below ~25%): financed mainly by equity — safe and resilient, but possibly under-using debt to grow.
High gearing (above ~50%): more than half the capital is debt — riskier, with heavy fixed interest, but potentially faster-growing through financial leverage.
No universal 'right' level: capital-intensive industries (utilities, airlines) run high gearing normally; service firms usually run low. Always judge against the industry and the firm's own trend.
Strategies to improve (reduce) gearing
When a firm is uncomfortably highly geared, it can move the ratio in two directions: shrink the debt (the numerator) or grow the equity (part of the denominator). Which route suits the business depends on its access to capital markets, its dividend policy and how much control the owners are willing to share.
Repay or refinance long-term loans: using retained profit or cash to pay down debt directly cuts the numerator — but consumes cash the firm may need elsewhere.
Issue new shares (raise equity): increases capital employed and lowers the debt share — but dilutes existing owners' control and, for a plc, invites market scrutiny.
Retain more profit: keeping earnings rather than paying dividends raises retained earnings and so capital employed — but disappoints shareholders wanting income.
Judge in context: a firm with volatile profits has a stronger case to de-gear; a stable, capital-intensive firm may reasonably keep high gearing to fund growth.
Efficiency ratios: managing the working-capital cycle
Efficiency ratios (also called activity ratios) measure how well a firm uses its assets and manages its short-term liabilities — the heart of working-capital management. The three in the syllabus map onto the working-capital cycle: the time it takes to turn stock into cash. Stock turnover shows how fast goods sell; debtor days shows how fast customers pay; creditor days shows how slowly the firm can pay its suppliers. Managing this cycle well is what keeps a profitable firm liquid.
Stock (inventory) turnover: more times per year (or fewer days) usually signals efficient selling and less capital tied up in stock — but the ideal depends on the industry. A grocer needs rapid turnover; a jeweller or car dealer normally has slow turnover of high-value items.
Debtor (receivables) days: lower is better — cash arrives sooner, protecting liquidity. Rising debtor days can signal weak credit control or customers in difficulty.
Creditor (payables) days: higher generally helps cash flow, as supplier credit finances the cycle — but paying too slowly risks losing discounts, damaging supplier goodwill or losing suppliers altogether.
The target relationship: aim for debtor days < creditor days, so cash comes in from customers before it must go out to suppliers — a self-financing, liquidity-friendly cycle.
Strategies to improve the efficiency ratios
Speed up stock turnover: adopt just-in-time or lean stock control, clear slow-moving lines with discounts, improve demand forecasting, and drop obsolete products — but avoid stockouts that lose sales.
Reduce debtor days: tighten credit control and vet customers, offer early-payment discounts, invoice promptly and chase overdue accounts, shorten credit terms, or use debt factoring — accepting that discounts and factoring reduce the cash received.
Lengthen creditor days (carefully): negotiate longer payment terms with suppliers to keep cash longer — but not so far that you lose early-payment discounts or damage supplier relationships and reliability.
Aim for the whole cycle: the goal is a shorter cash cycle overall — fast stock turnover, quick collection from debtors, and reasonable (not reckless) delay in paying creditors.
The limitations of ratio analysis
Ratios are powerful, but they are a torch, not a verdict. They are only as good as the accounts they come from, they describe the past, and they say nothing about the qualitative factors that often decide a firm's future. A strong HL answer uses ratios to open an investigation and then names their limits rather than treating a single number as proof.
Backward-looking: ratios are built from historical accounts and describe what has already happened, not what will happen next.
Comparison problems: different firms use different accounting policies (e.g. depreciation, stock valuation), and inflation distorts figures over time, so like-for-like comparison is hard.
No qualitative factors: ratios ignore staff morale, brand strength, management quality, innovation and market conditions — often the real drivers of success or failure.
Can be distorted: one-off events and 'window dressing' of accounts near the year-end can flatter or distort ratios.
Context-dependent: the same value is healthy in one industry and alarming in another, so a ratio means nothing without a benchmark — the firm's trend, competitors or industry norms.
Common mistakes examiners penalise
Confusing which denominator to use — debtor days uses SALES REVENUE; stock turnover and creditor days use COST OF GOODS SOLD. Swapping them is the single most common efficiency-ratio error and forfeits the method mark.
Thinking high gearing simply means 'more debt is always bad' — high gearing means MORE RISK, but it can also mean faster growth through leverage. State the risk AND the trade-off, not a blanket 'bad'.
Dropping the unit — a bare number with no %, 'times' or 'days' loses the accuracy mark. Every ratio needs its unit.
Forgetting to average the stock — when opening and closing stock are both given, average them before calculating stock turnover; using one figure loses the method mark.
Calling a ratio 'good' or 'bad' with no benchmark — a number in isolation earns little; the marks come from comparing it to the firm's trend, competitors or industry.
Mixing up gearing capital — gearing uses LONG-TERM (non-current) liabilities over CAPITAL EMPLOYED, not current liabilities or total assets. Capital employed = long-term liabilities + total equity.
Calculating without interpreting — a correct number with no comment cannot reach the interpretation marks; always say what the figure means for THIS business.
Model answer — marked the way our engine marks it
Because 3.6 is a quantitative topic, our marking engine assesses these answers with IB Business Management M (method) and A (accuracy) conventions rather than the essay-style AO bands. An M mark rewards the correct method — the right formula with the right figures substituted in — even if a slip earlier in the working feeds a wrong number into it (follow-through). An A mark rewards the accurate final value WITH its unit. Interpretation marks reward a valid, context-linked comment on what the numbers show. Watch how the marks below attach to method, to accurate values with units, and to a supported interpretation.
Where this leads
These ratios connect straight into the rest of the finance unit. Gearing builds on sources of finance (3.1) and feeds into any evaluation of expansion, borrowing and financial risk. The efficiency ratios extend working-capital and cash-flow management, showing why a profitable firm can still run short of cash. And the limitations of ratio analysis run through every quantitative judgement you make in Business Management. Master the habit built here — pick the right formula, substitute carefully, attach the unit, then interpret in context — and you have the template that earns marks on every calculation-and-comment question in the course.
Worked examples
See the formulas applied — reveal one step at a time, like the exam.
A company reports the following long-term funding at 31 December 2025:
- Long-term liabilities (loan capital):
- Share capital:
- Retained earnings:
Calculate the gearing ratio and comment on the result. [4]
- 1
Model answer.
For the year ended 31 December 2025, 'Meridian Traders' reports:
- Sales revenue:
- Cost of goods sold:
- Opening stock:
- Closing stock:
- Debtors (trade receivables):
- Creditors (trade payables):
Calculate the stock turnover (in days), debtor days and creditor days, and comment on the firm's working-capital management. [6]
- 1
Model answer.
A business has long-term liabilities of $300,000 and capital employed of $750,000. Its debtors are $40,000 and annual sales revenue is $500,000. Calculate the gearing ratio and the debtor days, and comment on what they show. [5]
- 1
Model answer.
How it all connects
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Glossary
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Quick check
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Revision flashcards
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Gearing ratio
The proportion of a firm's capital employed that is financed by long-term (non-current) debt. It shows how a business is financed and how exposed it is to financial risk from interest and repayment obligations.
Key takeaways
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- ✓
Capital employed = long-term (non-current) liabilities + total equity (share capital + retained earnings). It is the total long-term funding the business is using.
- ✓
Low gearing (below ~25%): financed mainly by equity — safe and resilient, but possibly under-using debt to grow.
- ✓
High gearing (above ~50%): more than half the capital is debt — riskier, with heavy fixed interest, but potentially faster-growing through financial leverage.
- ✓
No universal 'right' level: capital-intensive industries (utilities, airlines) run high gearing normally; service firms usually run low. Always judge against the industry and the firm's own trend.
Practice — then mark it
The whole point: a real Cambridge question, marked mark-by-mark.
Get a Paper 2 quantitative question marked: calculate the gearing and efficiency ratios, attach the units, and interpret them in context
Get a Paper 2 quantitative question marked: calculate the gearing and efficiency ratios, attach the units, and interpret them in context
Extra simulations & links
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Frequently asked
Checkpoint
One marked question is worth ten re-reads — close the loop before you move on.
Reading it isn’t knowing it — prove it.
Before you move on: do Get a Paper 2 quantitative question marked: calculate the gearing and efficiency ratios, attach the units, and interpret them in context on paper, snap a photo, and get examiner-style feedback on exactly where you win and lose marks.