Efficiency, gearing and limitations
Efficiency and gearing
- Efficiency ratios show how well resources are used — e.g. inventory turnover (how many times a year stock is sold and replaced). Faster turnover ties up less cash.
- Gearing shows how much long-term money is borrowed:
$$\text{gearing} = \frac{\text{non-current liabilities}}{\text{capital employed}} \times 100\%$$
- High gearing = heavy borrowing — risky if interest rates rise, but can boost returns in good times.
Practice
Non-current liabilities are 40,000 and capital employed is 100,000. What is the gearing (%)?
Gearing = non-current liabilities ÷ capital employed × 100% = 40,000 ÷ 100,000 × 100% = 40%.
Practice
High gearing is risky mainly because:
Heavy borrowing means large interest costs, which hurt if rates rise.
Limitations of ratios
- ratios use past data (may not predict the future),
- they ignore non-money factors (staff morale, brand),
- a fair comparison needs similar firms in the same industry.
Practice
Which are limitations of ratio analysis? (Choose all that apply.)
Ratios rely on past data, ignore non-money factors and need fair comparisons — they do not predict perfectly.
You've got it
Key idea
- inventory turnover = how often stock is sold/replaced; faster = less cash tied up
- gearing = non-current liabilities ÷ capital employed × 100%; high = risky borrowing
- ratios are limited: past data, ignore non-money factors, need fair comparisons