3.5.2 Ratio Analysis

Question 1

Gearing

Answer 1

LT financial health of business
LT liabilities as % of total long term capital
proportion of business capital provided by debt

-reliant borrowed money/vulnerable to financial setback
level of acceptable gearing depend on business/industry

Question 2

highly geared & 3 issues of it

Answer 2

debt used to fund all capital investment
50% + = high

issues:
1. high risk = no pay back =change demand/comp
2. vulnerable to change in interest rates
3. suffer in recession

Question 3

low gearing & 4 benefits

Answer 3

less than 20%

1. less risk of defaulting on debt
2. less exposed to interest rate change
3. SHs rather than debt providers = influence over bus
4. capacity to add debt if required

Question 4

3 reasons why Gearing is useful

Answer 4

1. measure business financial health
2. focus debt level - financial structure of bus
3. high gearing = high business risk (not always)

Question 5

Gearing formulae

Answer 5

non current liabilities divided by
total equity + non current liabilities
x100

Question 6

capital employed

Answer 6

money spent on investment 
total equity (net assets) + non current liabilities/long term

Question 7

total equity (net assets)

Answer 7

share capital + retained profit (reserves)

Question 8

3 benefits of high gearing

Answer 8

1. less capital required from SHs
2. debt= cheap source of finance
3. easy pay interest if strong profit and cash flow

Question 9

ROCE

Answer 9

Return on capital employed
operating profit as % of capital invested
shows return on capital

Question 10

3 reasons why ROCE is useful ?

Answer 10

1. evaluate profitability of investment
2. provide target return for future individual projects (help with investment appraisal)
3. benchmark performance with competitors/make comparisons over time

Question 11

ROCE equation

Answer 11

operating profit (income statement) divided by capital employed (SOFP/balance sheet) 
x100

Question 12

4 evaluation of ROCE

Answer 12

1-widely used measure of return on investment by bus
2-varies between industries
3-based on snapshot of business balance sheet
4-comparisons over time & with key competitors = most useful

Question 13

altering the gearing ratio

raising and lowering

Answer 13

raising:
- buy back ordinary shares,
- issue more preference shares
- obtain loans

lowering:
- issue ordinary shares,
- retain more profits
- repay loans

Question 14

ROCE VS ARR

Answer 14

ROCE:
actual, 1 yr, externally past inv = return
overall performance of all assets
OP divided by total eq + LT liabilities x100

ARR:
single inv, forecast, 3/5yrs, invest in future, internal
net cash flow (av annual profit) divided by av investment

Question 15

types of ratio

Answer 15

1. profitability
2. liquidity (CR & AT)
3. gearing

Question 16

3 ways to reduce high gearing ..

Answer 16

1. issue more shares
2. retain more profit
3. repay loans

Question 17

2 ways to boost ROCE ratio

Answer 17

1. increase operating profit

2. reduce capital employed

Question 18

3 limitations of ratio analysis

Answer 18

1. lack of detail
2. stock out of fashion - misleading picture?
3. net profit - one off transactions?