Ratio analysis Flashcards
What is a ratio?
A ratio measures a company’s ability to meet financial obligations.
What is the current ratio formula?
Current assets/ current liabilities
What is a current ratio?
This is also known as the working capital ratio
The ideal is around 1.5:1 and 2:1
Below 1.5:1 the business might not have enough working capital to cover all their bills
They may be over borrowing or over trading and will have cash flow problems
Above 2:1 and the money in the business is tied up and not being used efficiently
What is the formula for acid test ratio?
Current liabilities
What is acid test ratio?
The acid test ratio is also known as the quick ratio and is the most commonly used ratio to judge the financial health of a business
Stock is excluded because it may perish or be obsolete or not worth the stated value
A result of less than 1:1 means that the current assets do not meet their current liabilities and they will struggle to pay their bills
What is the formula for gearing ratio?
Non-current liabilities
—————————— x 100
Capital employed
Answer should be a percentage
What is gearing ratio?
The gearing ratio looks at the long-term finance of the business and where it comes from
A result of over 50% means the business is highly geared, most of the money comes from loans, this is very risky for a potential investor
A result of less than 50% means the business is low geared and most of the money comes from the owners, a better risk for an investment
What is the formula for ROCE ratio?
Operating profit
—————————— x 100
Capital employed
answer should be a percentage
What is ROCE ratio?
Return on Capital employed is a measure of the profitability of the business
If you were considering investing in a business you might calculate the ROCE % and then compare this against a bank savings plan (less risky) of 5%
The higher the ROCE figure the better
Demonstrates how hard the business made the money invested work
What are the limitations of ratios?
The balance sheet is just a snapshot of the business on one day, if the ratios are based on this figure, then it’s a ratio of just one day in the business and as markets are dynamic figures could change
The ratios are only as good as the information provided in the balance sheet and the profit and loss
The ratios need comparison like a pair of shoes you need two to be comfortable. For example 45% on doesn’t tell us everything but a rise from 45% to 87% means something more. We also need to know the circumstances to gain a full picture.
Ratios must be seen in an industry context. In some supermarkets the current ratio is very low as the stock is sold so fast , so a low current ratio or acid ratio would not be a worry
Keep in context – poor ratios in a time of world recession (2008) is likely due to the economy not just the business
During a recession, for example, it may be useful to compare the business performance with a competitor
