3.5.2 Ratio Analysis Flashcards
what is the gearing ratio
- shows how much money is generated from non-current liabilities
what is capital employed
the total amount of finance that a business has acquired
how is gearing ratio calculated
non-current liabilities / capital employed X100
what does the gearing ratio tell us
- shows how vulnerable a business is to changes in interest rates
- high geared = over 50%, means lots of finance is acquired from long term debt
- low geared = below 50%, means little finance is acquired through long term debt
- higher gearing ratios mean the business is affected more by changes in interest rates as it will change how much their repayments are
what are the rewards of having a high gearing ratio
+ lots of money is available for investment
+ it may indicate a high level of growth, the money borrowed is funding expansion
what are the risks of a high gearing ratio
- the business can have to pay more on their loan repayments which they may not be able to afford
- can be risky to take out loans even when interest rates are low because these may rise
what is ROCE
- return on capital employed
- operating profit / capital employed X100
- 10% means that 10p is made for every £1 that is invested
why would a business use ROCE
- it is a measure of profitability
- can be compared to Bank of england base interest rate, if the base rate is higher then the business would be better off keeping the money in the bank than investing
benefits of ratio analysis
+ helps measure and monitor performance
+ helps business make decisions and necessary changes
+ used to obtain finance from lenders and shareholders
+ can be compared to other firms to consider other factors like the economic climate
drawbacks of ratio analysis
- ignores non-financial factors like economic climate, staff quality
- future changes in interest rates can’t be predicted
- ratios explain past and present but don’t necessarily predict whether a firm will be successful and get a large return on investment in the future
