3.5 Ratio analysis Flashcards
Ratio analysis
Extracting information from financial accounts to assess business performance
What two financial accounts are used?
Income statement
Balance sheet
What steps are taken with ratio analysis?
Collect data
Calculate ratio
Interpret results
Use to make decisions
Gearing ratio
Proportion of business assets financed by long term borrowing
What is the gearing ratio formula?
Non current liabilities/capital employed x 100
How do you work out capital employed?
Total assets- current liabilities
Highly geared business
More than 50% of capital employed are long term loans.
Disadvantages of being a highly geared business
Dividends to shareholders reduced
Profit limited
Risk for future investment
How to reduce gearing?
Issue ordinary shares to create share capital
Retain more profits
Repay loans with lower interest
Low geared businesses
Less than 50% of capital employed as long term loans
Disadvantages of low geared businesses
Missing out on opportunity to access finance
Risk averse business so deter investors
How to increase gearing?
Buying back ordinary shares to reduce share capital
Obtain more loans
What is return on capital employed?
How effectively a business uses capital invested to generate profit
Return on capital formula
Operating profit/capital employed x 100
What are the advantages of interpreting return on capital employed?
Can be compared with business in same industry
Support strategic decisions
Compare with interest rates on savings
What is better a high or low return on capital?
A high rate
Why is a high rate of return on capital good?
Indicates business is profitable and has a low risk of growth
How to increase return on capital?
Increase level of profit without introducing new capital.
Maintain level of profit whilst reducing capital.
What are the limitations of ratio analysis?
Comparisons between firms are only meaningful if significant similarities.
Accounts may be manipulated and this will affect the quality of ratio analysis .
Key qualitative factors
What are the benefits of ratio analysis?
Venture capitalists use when investing or lending
Banks and insurance providers use to determine risk
Journalists use to report to media
What are the benefits of high gearing?
Easy to pay interest if profits and cash flow strong.
Less capital required by shareholders.
What are the benefits of low gearing?
Business has capacity to add debts
Less risk
