3.5.2 - Ratio Analysis

Question 1

What does a ratio measure

Answer 1

• A ratio measures a company’s ability to meet financial obligations.

Question 2

What is the current ratio formula

Answer 2

Current Assets /
Current Liabilities

• 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

Question 3

What is the acid test ratio

Answer 3

CurrentAssets - Inventory /
CurrentLiabilities

• 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

Question 4

What is the gearing ratio

Answer 4

Non-current Liabilities / CapitalEmployed

X100

• 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

Question 5

What is an ROCE ratio

Answer 5

Operating Profit /
CapitalEmployed
X100

• 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

Question 6

What are the limitations of ratios

Answer 6

• 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 its own means nothing but a rise from 45% to 87% means something