3.5 Ratio analysis

Question 1

Ratio analysis

Answer 1

Extracting information from financial accounts to assess business performance

Question 2

What two financial accounts are used?

Answer 2

Income statement
Balance sheet

Question 3

What steps are taken with ratio analysis?

Answer 3

Collect data
Calculate ratio
Interpret results
Use to make decisions

Question 4

Gearing ratio

Answer 4

Proportion of business assets financed by long term borrowing

Question 5

What is the gearing ratio formula?

Answer 5

Non current liabilities/capital employed x 100

Question 6

How do you work out capital employed?

Answer 6

Total assets- current liabilities

Question 7

Highly geared business

Answer 7

More than 50% of capital employed are long term loans.

Question 8

Disadvantages of being a highly geared business

Answer 8

Dividends to shareholders reduced
Profit limited
Risk for future investment

Question 9

How to reduce gearing?

Answer 9

Issue ordinary shares to create share capital
Retain more profits
Repay loans with lower interest

Question 10

Low geared businesses

Answer 10

Less than 50% of capital employed as long term loans

Question 11

Disadvantages of low geared businesses

Answer 11

Missing out on opportunity to access finance
Risk averse business so deter investors

Question 12

How to increase gearing?

Answer 12

Buying back ordinary shares to reduce share capital
Obtain more loans

Question 13

What is return on capital employed?

Answer 13

How effectively a business uses capital invested to generate profit

Question 14

Return on capital formula

Answer 14

Operating profit/capital employed x 100

Question 15

What are the advantages of interpreting return on capital employed?

Answer 15

Can be compared with business in same industry
Support strategic decisions
Compare with interest rates on savings

Question 16

What is better a high or low return on capital?

Answer 16

A high rate

Question 17

Why is a high rate of return on capital good?

Answer 17

Indicates business is profitable and has a low risk of growth

Question 18

How to increase return on capital?

Answer 18

Increase level of profit without introducing new capital.
Maintain level of profit whilst reducing capital.

Question 19

What are the limitations of ratio analysis?

Answer 19

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

Question 20

What are the benefits of ratio analysis?

Answer 20

Venture capitalists use when investing or lending
Banks and insurance providers use to determine risk
Journalists use to report to media

Question 21

What are the benefits of high gearing?

Answer 21

Easy to pay interest if profits and cash flow strong.
Less capital required by shareholders.

Question 22

What are the benefits of low gearing?

Answer 22

Business has capacity to add debts
Less risk