Theme 3 - 3.5.2 - Ratio Analysis Flashcards
What is the current ratio formula ?
Current assets / current liabilities = current ratio
Your answer should be expressed as a ratio to 1 so for e.g. 3:1 etc
A figure of more than 1 is ideal as this means that all of the current liabilities can be paid off with the current assets available to the business whereas a ratio of less then 1 may indicate the business is having issues with liquidity - so the first number of the ratio should ideally be more than one as you would have more assets to liabilities
However with a ratio of more than 2:1 this is also bad because if you have more than 2:1 then that means your not using your money effectively in the business so for example your not using it to invest in new ventures etc
What is the acid test ratio ?
It’s the most common ratio to use to calculate the financial health of the business
Stock is excluded because it may perish or be obsolete or not worth the stated value —> if stock is on the shelves it doesn’t mean that its getting bought
It’s the same as the current ratio where it’s displayed as x:1 and if its more than one then it would have strong liquidity and if its under 1 then it might struggle to pay off debts
- cash can be immediately used
- trade receivables can be turned into cash within 30 days
- stock/inventory might not be even bought
What is the gearing ratio ?
Non-current liabilities / capital employed x 100
Non-current aka long term
The answer should be expressed as a percentage
It is used to assess the degree to which a company is financed by debt rather than its equity - it indicates the proportion of the businesses capital that comes from borrowing rather than from the shareholders funds - this method helps stakeholders understand the financial risk level of the company because if most of the money comes from debt then it generally means its more risky to invest in as the debt can catch up to them
What is a good gearing ratio ?
Low gearing - typically considered safe - with ratios below 25% - companies with low gearing rely on equity rather than debt ( borrowing money to raise capital )
Moderate gearing - ratios between 25% and 50% these are common in stable industries
High gearing - ratios above 50% are seen as risky as you have a lot of debt - high gearing is common in capital-intensive sectors
Whats the return on capital employed percentage ( ROCE ) ?
ROCE is a measure of profitability - a measure of how much of a return has been made on an investment
The higher the ROCE the better
TO get capital employed - non-current liabilities + total equity
Operating profit / Capital Employed x100
