Key Idea: Profit and liquidity are not the whole story: a business must also turn its stock and its debts into cash quickly, and not borrow too much. This topic is the ratios that measure both, and what happens when it fails.
Efficiency ratios
- Stock turnover = cost of sales ÷ average stock (times), or average stock ÷ cost of sales × 365 (days).
- Debtor days = debtors ÷ sales revenue × 365.
- Creditor days = creditors ÷ cost of sales × 365.
Gearing
- Gearing = non-current liabilities ÷ capital employed × 100.
- Capital employed = non-current liabilities + total equity.
- Lena's: $350,000 ÷ $700,000 × 100 = 50.00%.
When it goes wrong
- Insolvency: a business cannot pay its debts when they are due.
- Bankruptcy: the legal process an insolvent business enters, overseen by a court.
- A profitable business can still become insolvent if its cash runs out.
The words to know
| Word | Means | Do not confuse with |
|---|---|---|
| Stock turnover | how many times a year, or how many days, stock takes to be sold | sales revenue |
| Debtor days | the average number of days customers take to pay | creditor days, how long the business takes to pay |
| Creditor days | the average number of days the business takes to pay its suppliers | debtor days |
| Gearing ratio | the share of capital employed that comes from long-term borrowing | the current ratio, which measures liquidity |
| Insolvency | being unable to pay debts when they fall due, or owing more than the business owns | making a loss: a loss-making business can still pay for a while |
| Bankruptcy | a legal process, overseen by a court, for a business that cannot pay its debts: a rescue plan or the sale of its assets | insolvency, which is the financial position, not the legal process |
For a calculation: formula, figures from the case, answer with the unit (times, days or %), working shown. For a comment: is it high or low, better or worse than before or than the terms given, and what that means for this business's cash.
Exam-style question
At 31 December 2025 Lena's Bakery Ltd's debtors were $40,000. Its sales revenue for 2025 was $1,600,000. Calculate the bakery's debtor days (show all your working).
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Important: Fewer debtor days is better: cash comes in sooner. More creditor days helps cash, but only while suppliers are still happy. Higher gearing is not always bad: say what the loan paid for and whether the business can afford the interest.
Tap each card to check yourself.
Lena's creditor days are 34.2 and Valley Grain gives 30 days. Comment. The bakery pays about four days late: good for its cash, but it risks its main supplier's goodwill.
Stock turnover at Lena's is 32 times a year. Why is that about right for a bakery? Flour and ingredients must be used fresh, so stock should be turned over quickly.
Name one way to lower debtor days. Any one: shorter credit terms, a discount for paying early, chasing late payers, credit checks on new customers.
Goldcrust's gearing is 36.00%. Is it highly geared? No. Most of its capital employed comes from equity, not long-term loans.
Name one way to reduce gearing. Any one: issue new shares, repay long-term loans, keep more profit instead of paying dividends.
Can a profitable business become insolvent? Yes. If customers pay slowly or cash is tied up in stock or new assets, it can run out of cash while still making a profit.
Exam tips
- Learn which figure goes on the bottom: sales revenue for debtor days, cost of sales for creditor days and stock turnover.
- Always give the unit: times, days or %.
- Compare the result with something in the case: last year, the credit terms, a rival.
- Gearing uses capital employed, which is non-current liabilities plus total equity.
- Insolvency is about paying debts on time, not about profit.