IB Business Management HLTopic 3 — Finance and AccountsPaper 1 & 2HL only~9 min read
Stock Turnover and Gearing
Efficiency ratios ask whether a business is using what it has sensibly. Stock turnover looks at the things on the shelves. Gearing looks at where the money to buy those shelves came from. Both are HL only, and both come up as short calculations followed by a big “so what?”.
What you need to know
Efficiency ratios show how well a firm uses its assets and liabilities to generate sales and profit.
Average stock = (opening stock + closing stock) ÷ 2. Work this out first, every time.
Stock turnover can be given as number of times (cost of sales ÷ average stock) or number of days (average stock ÷ cost of sales × 365).
Firms want a high number of times, which is the same as a low number of days.
Gearing = (non-current liabilities ÷ capital employed) × 100. It shows how much of the long-term funding is borrowed.
Above 50% is highly geared; below 50% is low geared.
Stock turnover: how fast do the shelves empty?
Stock sitting in a warehouse is money doing nothing. It costs rent, insurance and security, and it might go out of date. Stock turnover measures how quickly a business converts that stock into sales.
Number of times stock is sold in a year
cost of sales ÷ average stock
Number of days to sell the stock
(average stock ÷ cost of sales) × 365
The two versions are the same fact in different clothes. If stock turns over 6.5 times a year, that is 365 ÷ 6.5, which is about 56 days per turn. Use it to check your own answer.
There is no correct number
A high turnover is good for most firms, but the “right” figure depends entirely on what is being sold. A bakery that takes 56 days to shift its stock is throwing away bread. A jeweller that turns stock over 30 times a year has probably priced its diamonds like biscuits.
A “bad” figure for one business is completely normal for another, so always judge the ratio against the business model in the case study.
WORKED EXAMPLE 1
Stock turnover both ways
Kabir Cycles held stock worth $52,000 on 1 January and $44,000 on 31 December. Cost of sales for the year was $312,000. Calculate the stock turnover in times and in days. [4]
Step 1: average stock(52,000 + 44,000) ÷ 2 = 96,000 ÷ 2 = $48,000Step 2: number of times312,000 ÷ 48,000 = 6.56.5 times a yearStep 3: number of days(48,000 ÷ 312,000) × 365 = 0.1538 × 36556.15 daysCheck: 365 ÷ 6.5 = 56.15. The two answers agree, so the working is sound.
Ways to improve stock turnover
Hold less stock. Order more often in smaller batches, or move towards just-in-time.
Clear the dead stock. Discount obsolete or slow lines rather than storing them forever.
Narrow the range. Focus on the lines that actually sell.
Cut the cost of sales. Cheaper suppliers or bulk deals raise the “times” figure too — but bulk buying pushes average stock up, which works against you.
Careful with the trade-off. Holding very little stock makes the ratio look excellent right up to the day a delivery is late and the shop has nothing to sell.
Gearing: whose money is the business using?
Every business is funded by a mix of borrowed money (long-term loans) and owners’ money (equity). Gearing tells you the split. It matters because loans must be repaid with interest whether the business is doing well or not, while shareholders can simply be paid less in a bad year.
Gearing ratio
(non-current liabilities ÷ capital employed) × 100
Capital employed
non-current liabilities + equity
The red block is money that must be serviced with interest payments in good years and bad.
WORKED EXAMPLE 2
Gearing for two firms
Kabir Cycles has non-current liabilities of $180,000 and capital employed of $480,000. Orbit Outdoors has non-current liabilities of $320,000 and equity of $180,000. Calculate the gearing ratio of each. [4]
Step 1: Kabir — capital employed is given(180,000 ÷ 480,000) × 100 = 0.375 × 10037.50% — low gearedStep 2: Orbit — build capital employed first320,000 + 180,000 = $500,000(320,000 ÷ 500,000) × 100 = 0.64 × 10064.00% — highly gearedNearly two thirds of Orbit’s long-term funding is borrowed, so a rise in interest rates hits Orbit far harder than Kabir.
Why high gearing is risky
Area of risk
What actually happens
Interest rates
If rates rise, repayments rise with them and profit falls, even though sales have not changed
Cash flow
Loan repayments are fixed. In a downturn the business still has to find the money
Investment
Cash going out as interest cannot be spent on new products or equipment
Shareholders
Less profit is left for dividends, and the share price may suffer
Credit rating
Lenders see a risky borrower, so future loans cost more or are refused
When high gearing is fine
Interest rates are low and expected to stay low, so borrowing is cheap.
The firm is large and profitable with reliable cash flow, so it can comfortably meet repayments.
The borrowing is funding growth that will pay for itself, such as a factory that raises output.
Ways to lower gearing
Repay long-term debt, starting with the most expensive loans.
Issue new shares or hold a rights issue to raise equity instead.
Retain profit rather than paying it out as dividends, which builds equity from inside.
Renegotiate with lenders to restructure or extend existing debt.
Exam tip
Calculate average stock first and label it. Missing this step costs the first mark.
Stock turnover uses cost of sales, never revenue.
Gearing uses non-current liabilities. Overdrafts and creditors are current, so they stay out.
If the question gives you equity and long-term loans but not capital employed, add them together.
When you evaluate gearing, always name the interest rate environment in the case study.
Give both ratios to two decimal places and add the unit: times, days or a percentage.
Common mix-up
Using closing stock instead of average stock. The formula asks for the average of the two figures.
Dividing average stock by cost of sales when the question wants “times”. That gives you the fraction of a year, not the number of turns.
Saying a high stock turnover is always better. It can also mean stock-outs and lost sales.
Putting current liabilities into gearing. Only long-term borrowing counts.
Claiming high gearing always means failure. Many large, stable firms are deliberately highly geared.
Mixing up gearing with liquidity. Gearing is about long-term structure; liquidity is about paying next month’s bills.
Up next: HL Debtor Days and Creditor Days — the two ratios that decide whether cash arrives before or after the bills do.
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