3.5.2 Ratio analysis Flashcards
what is gearing?
it measures the proportion of a business’ capital provided by debt
highly geared means…?
a business has more debt than equity
the gearing ratio is useful because…?
-measure of the financial health of a business
-focuses on the level of debt in the financial structure of a business
-high gearing can mean high business risk, not always
(because lenders may demand their money back at any point)
what are ways to measure the gearing?
-gearing ratio
-debt to equity
what is the formula for the debt to equity ratio?
debt / equity
what is the formula for the gearing ratio?
gearing ratio = non current liabilities /
total equity + non current liabilities
(capital employed)
x100
how is the gearing ratio said…?
if the answer was 25%:
for every £1 capital employed, 25p is debt
evaluation for gearing…?
-gearing ratio of 50% or above is high
-gearing of less than 20% is low
-but level of acceptable gearing depends on the business and the industry
benefits of high gearing…?
-less capital required to be invested by the shareholders so less need to issue shares and lose control of the business
-easy to pay interest if profits and cash flows are strong
-debt interest is deducted before corporatation tax is calculated
benefits of low gearing…?
-less risk of defaulting on debts
-shareholders rather than debts providers ‘call the shots’
-business has capacity to add debt if required
what is Return On Capital Employed (ROCE)?
-a way of measuring business performance
-a way of convincing to be loaned money
benefits of ROCE…?
-evaluation of a business’ performance
-provide a target return for individual projects
-benchmark (compare) performance with competitors
drawbacks of ROCE…?
-varies between industries
-based on a snapshot of a business’ balance sheet
-comparisons continue with key competitors most useful
-more profit doesn’t mean more profitable
what is the formula for ROCE?
operating profit (or net) / capital employed
