3.5.2 Ratio Analysis

Question 1

What is ratio analysis?

Answer 1

• Involves extracting information from financial accounts to assess business performance

Question 2

What information is extracted from a profit & loss account?

Answer 2

• Revenue
• Cost of Sales
• Gross Profit
• Operating Profit
• Profit for the Year (Net profit)

Question 3

What information is extracted from a balance sheet?

Answer 3

• Current Assets
• Current Liabilities
• Inventory (stock)
• Trade Receivables
• Trade Payables
• Long-term liabilities
• Capital & Reserves

Question 4

What does the gearing ratio measure?

Answer 4

• Measures the proportion of assets invested in a business that are financed by long-term borrowing.

In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest & repayment of debts are not “optional” in the same way as dividends.

Question 5

What is the formula used to work out the gearing ratio?

Answer 5

• Non-current liabilities/ total equity + non current liabilities (CE) X100

Question 6

What is a highly geared business?

Answer 6

• A business that has a gearing ratio of 50% +

Question 7

What is a low gearing business?

Answer 7

• A business with gearing of less than 25%

Question 8

What is classed as a ‘normally geared’ business?

Answer 8

• Gearing between 25%- 50% would be considered normal for a well-established business which is happy to finance its activities using debt.

Question 9

What are the benefits of high gearing?

Answer 9

• Less capital required to be invested by shareholders
• Debt can be a relatively cheap source of finance compared w dividends
• Easy to pay interest if profits & cashflows are strong

Question 10

What are the benefits of low gearing?

Answer 10

• Less risk of defaulting on debts
• Shareholders rather than debt providers ‘call the shots’
• Business has the capacity to add debt if required

Question 11

What ways are there to reduce gearing?

Answer 11

• Focus on profit improvement (e.g. cost minimisation)
• Repay long-term loans
• Issue more shares
• Convert loans into equity

Question 12

What ways are there to increase gearing?

Answer 12

• 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 debentures

Question 13

What is the return on captial employed (ROCE)?

Answer 13

• It tells us what returns (profits) the business has made on the resources available to it.

leased equipment will not be included in ROCE

(also known as primary ratio)

Question 14

How do you calculate return on capital employed (ROCE)?

Answer 14

• Operating profit/ Capital employed X100

Capital employed normally comprises: Share capital + Retained Earnings + Long-term borrowings

Question 15

How do you work out capital employed?

Answer 15

• Total equity + non-current liabilities

Question 16

How would you measure capital employed?

Answer 16

• With ROCE, the higher the percentage figure, the better.
• High ROCE is good, shows company is offering good return on the funds provided by shareholders & on any LT loans made to the business
• The figure needs to be compared with the ROCE from previous years to see if there is a trend of ROCE rising/ falling.

Question 17

How can a business improve ROCE?

Answer 17

• Improve the top line (i.e. increase operating profit) without a corresponding increase in capital employed
• Maintain operating profit but reduce the value of capital employed
• Increase the level of profit generated without introducing new capital into the business
• Maintain level of profit generated whilst reducing amount of capital in the business

Question 18

What are the limitations of ratio analysis?

Answer 18

• Making Comparisons
  It is important to compare like for like
  Over time, the nature of a business can change, affecting the desired level of ratio
  E.g. a business may diversify into a less competitive industry where higher levels of RoCE may be expected
  -Quality of accounts- Accounts may have been legally manipulated to present a particular financial picture.E.g. Bad debts can be written off, Property can be revalued, Income & costs may be reported during an earlier or later reporting period (e.g. payments to suppliers may be delayed to maximise the level of current assets
  Window dressing will have an impact on the quality of ratio analysis calculations
• Qualitative Information- As ratios only use numerical data from a businesses accounts key qualitative factors that affect its performance are ignored.

Question 19

What types of businesses would benefit from the different types of gearing?

Answer 19

• A mature business which produces strong & reliable cash flows can handle a much higher level of gearing than a business where the cash flows are unpredictable