Chapter 61- Ratio Analysis

Question 1

Gearing Ratio

Answer 1

Non-current liabilities / capital (money) x100

Question 2

What does the Gearing Ratio show

Answer 2

The gearing ratio shows the relationship between long term liabilities (bank loans) and capital employed, sometimes known as equity shareholders’ funds. It is desirable for firms to keep the ratio of bank loans to shareholders funds relatively low i.e. less than 50% because interest payments on bank loans have to be paid.

In theory shareholders do not have to paid dividends. Ideally a firm should be a low geared firm, one which is not reliant on banks for finance.

Profitability or performance ratios help to show how well a business is doing. They tend to focus on profit, capital employed and revenue.

The profit figure alone is not a useful performance indicator. It is necessary to look at the value of profit in relation to the value of revenue or the amount of money that has been invested into the business.

Question 3

Return on Capital Employed, ROCE

Answer 3

= Operating profit/capital employed x100

Question 4

What does ROCE show

Answer 4

This ratio is an important profitability ratio because it identifies how good the company is at converting the initial investment into profit.

Question 5

Limitations to Ratio analysis:

Answer 5

• Comparisons over time, care must be taken when comparing ratios over time as some business may diversify and change rapidly as well as others that may experience rapid growth or shrink rapidly, this affecting the ratios in place. E.g. ratio will change if small company in Defence Company, grows rapidly into leading telecommunications manufacturer.
• Inter-firm comparisons, comparing ratios for companies in same industry only gives broad relative performance – e.g. wouldn’t compare cement company to Supermarket Company.
• Also this is risky as companies in same market may have different purposes or aims = profit margins e.g. Tesco sell more tech unlike Waitrose which sells more food.
• Other differences, even comparing well matched companies in activities + circumstances, there will also be differences. E.g. companies may use different accounting techniques, different stock evaluation methods therefore comparisons may be misleading. OR ending on different financial year.
• The quality of final accounts, accuracy depends on accuracy of balance sheet + income statements – chance of window dressing, rising prices or high inflation could affect accounting.

Question 6

Ratio Analysis

Answer 6

A numerical approach to investigate accounts by comparing two related figures.

Question 7

Gearing Ratios

Answer 7

Exploration of capital structure of the business by comparing the proportions of capital raised by debt + equity.

Question 8

Performance Ratios

Answer 8

iIlustration of the relative profitability of business.

Question 9

Return On Capital Employed (ROCE)

Answer 9

Profit of a business as a % of total amount of money used to generate.

Question 10

Window Dressing

Answer 10

legal manipulation of accounts by a business to present financial picture to its benefits.