3.5.2 Ratio analysis 🔢 Flashcards
What is the gearing ratio formula?
Noncurrent liabilities/capital employed * 100
What is capital employed?
Amount of capital in the business
What does the gearing ratio look at
The long-term finance and where it comes from
What happens if the gearing ratio formula is over 50%?
Highly geared - most money from loans -risky for potential investors
What happens if you’re gearing ratio formula is less than 50%?
Business is low geared most - money comes from owners - lower risk for investment
What is the profitability or ROCE ratio formula
Operating profit/ capital employed *100
Where do we get the operating profit from for ROCE ?
State of comprehensive income
Where do we get capital employed?
State or financial position
How do we calculate capital employed?
Noncurrent liabilities + total equity figures (or assets)
What is the ROC E ratio formula and measure of?
Profitability
What happens if the ROCE ratio percentage is less than 5%?
Less risky
What’s better a high or low of ROCE
High
What does the ROCE demonstrate?
How hard the business that makes the money invested work
What are the four limitations of ratio analysis?
Making comparisons - Over time the nature of a business can change affecting the desired level of ratio
Comparisons between firms are only meaningful where significant similarities exist
quality of accounts - Accounts may have been legally (manipulated) to present a particular financial picture.
Bad debts can be written off
balance sheet limitations - at a specific point of time the balance sheet may not be representative of its usual circumstances
E.g. business sells a large amount of stock - rendering current and non-current assets figures invalid almost immediately
Qualitative accounts - key qualitative factors that affect its performance are ignored
Increased profit increases the RoCE without any strategic decisions being made
Basis of comparison - Very important to compare like with like
Comparison over time-Care must be taken with comparing ratios with the same company at the time - may change
Interfirm comparisons -may be on football as they need different amounts of working capital - profit margins drivgernt
Quality of accounts - can distort the ratios if there is a rise in price by inflation
Limitations of the balance sheet - snap shot of the business at the end of the year does not take into account circumstances throughout whole year slow or fast trading times
Other differences - could’ve ended in different years different methods to calculate depreciation
Qualitative information is ignored - does not tell us why
Windowdressing - legal manipulation of a business financier to present a picture that is to its benefit -
Legal reporting standards make businesses present true information and prevent fraud
however businesses manipulate this
managers want to put a good financial picture for potential shareholders
business wants to raise new capital from investors
if owners want business to sell they’ll be able to charge a higher price and
write off bad debt
What is ratio analysis?
Involves extracting information from financial accounts to assess business performance
