Ratio Analysis Flashcards
Define RATIO ANALYSIS
Ratio analysis is an examination of accounting data by relating one figure to another. This allows for more meaningful interpretation of the data and the identification of trends.
What are the three key types of ratio?
- Liquidity ratios - current ratio and acid test ratio
- Profitability margins - gross profit, operating profit, net profit and ROCE.
- The gearing ratio
Define RETURN ON CAPITAL EMPLOYED
ROCE measure how much profit is made by a business compared to how much capital has been invested.
What is the formula for ROCE?
ROCE = (operating profit/capital employed) x 100
How can low ROCE be improved?
- Increasing long term profit, without increasing loans.
- Repaying some long term loans, which then reduces capital employed
What should ROCE be compared to?
- ROCE from previous years
- ROCE of competitors
- Current base rate of interest
Define the GEARING RATIO
The gearing ratio measures the percentage of total capital employed in a firm that comes from long term loans (non-current liabilities).
What is the formula for gearing?
Gearing = (non current liabilities/capital employed) x 100
Define HIGHLY GEARED
A business is said to be highly geared if more than 50% of its total capital employed exists in the form of loans.
Define LOWLY GEARED
A business is said to be lowly geared if less than 25% of its total capital employed exists in the form of loans.
What are the features of a highly geared business?
- Vulnerable to changes in interest rates
- Shows that a firm is willing to take risks
- Difficulty keeping up with loan repayments if profit falls.
- Risky in a slow economy as payment will still need to be made.
What are the features of a lowly geared business?
- Shows the business may be risk averse and therefore they miss out on growth opportunities.
- Will have less difficulty repaying loans if profit falls.
- Can take out additional loans to fund new projects if necessary.
- Less risky when the economy is slowing down.
What are the limitations of ratios?
- Need to be compared over a period of time to get an idea of trends.
- Only as reliable as the documents they are based on.
- Comparison with competitors is needed to get industry context and identify which factors can be controlled by the business and which affect all businesses.
- Qualitative factors are ignored
- Product portfolio and product development are ignored.
- External economic factors or changes in a firm’s competitive environment are not reflected in statements.