3.5.2 Ratio analysis

Question 1

Gearing

Answer 1

Measures the proportion of a businesses choral provided by debt

Capital structure of a business - equity and debt
Equity - amounts invested by owners - share capital, retained profits
Debt - provided by external parties - bank loans + other long term loans

Reasons for higher equity - where there is greater risk
Where more flexibility required

Higher debt - where interest rates are low = debt is cheap
Where profits and cashflows are strong - can be repaid easy

Question 2

Why is gearing ratio useful

Answer 2

• measures financial health of a business
• focusses on the level of debt in the financial structure of a business
• high gearing can mean high business risk (not always)

Question 3

Gearing calculation

Answer 3

non curent liabilities ÷ (total equity + non luttent liabilities) X 100 = _%

Question 4

Evaluating gearing

Answer 4

Ratio 50% + said to be high - may experience difficulty borrowing later
less than 20% = low
Acceptable level depends on business and industry

Question 5

Benefits of high and low gearing

Answer 5

High benefits -
less capital required to be invested by shareholders
debt can be relatively cheap source of finance compared with dividends
easy to pay interest if profits and cash flows are strong

Low benefits -
Less risk defaulting on debts
shareholders rather than debt providers call the shot s
Business has the capacity to add debt if required

Question 6

Ways to manage gearing

Answer 6

Reduce - 
Focus on profit improvement 
Repay long term loans 
Retain profits rather than pay dividends 
Issue more shares
Convert loans into equity 

Increase -
Focus on growth -invest in revenue growth rather than profit
Convert short term debt into long term loans
Buy back ordinary shares
Pay increased dividends out of retained earnings
Issue preference shares or debtors

Question 7

Return on capital employed - ROCE

Answer 7

Measure of relative profitability
ROCE tells us what returns the business has made on resources available
ROCE is particularly useful as a ratio it helps
- evaluate the overall performance of the business
- provide a target return for individual projects
- benchmark performance with competitors

Question 8

Calculating ROCE

Answer 8

operating profit ÷ (total equity + non current liabilities) x100

Capital employed = total equity + non - current liabilities
Total equity = assets - liabilities

Question 9

Evaluating ROCE

Answer 9

• Widely used measure of return on investment by businesses

Key points to remember
ROCE will vary between industries
It is based on a snapshot of a businesses balance sheet
Comparisons over time and with key competitors are most useful

Question 10

Ratio Analysis

Answer 10

Involves comparison of financial data to gain insights into business performance
Helps answer questions such as
- why one business is more profitable
- what returns are being earned in investment in a business
- is a business able to stay solvent
- how effectively a business is using its assets

Question 11

Liquidy ratios

Answer 11

Asses whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall

Current ratio - current assets ÷ current liabilities = _ : 1
Acid test - current assets - inventory ÷ current liabilities

Question 12

Evaluating CR + ATR

Answer 12

Evaluating - CR 1.5-2.5 = efficient management of working capital
Low = liquidity problems
High = too much working capital

High - too much money, too much stock - may need to sell

• implement better stock management
• chase debtors
• implement better invoice system

ATR
Better indicator of liquid problems for businesses that hold stock
Significantly less than 1 = bad

Look out for -
Less relevant for business with high stock turnover (supermarket)
Trend : significant deterioration in the ratio can indicate a liquidity problem