Ratio analysis 3.5.2

Question 1

What is ratio analysis?

Answer 1

Ratio analysis involves the comparison of financial data to gain insights into business performance.

Question 2

Ratio Analysis Helps Answer Questions Such As…

Answer 2

Why is one business more profitable than another?

What returns are being earned in investment in a business?

Is a business able to stay solvent?

How effectively is a business using its assets?

Question 3

Where Does the Information for Ratio Analysis Come From?

Answer 3

Statement of comprehensive income

Statement of financial position

Question 4

What are the key stages in ratio analysis?

Answer 4

Gather data
Calculate ratios
Interpret results
Take action

Question 5

What are the main groups of ratios?

Answer 5

Profitability:
Gross profit
Operating profit
Return of capital employed

Liquidity:
Current ratio
Acid test ratio

Financial efficiency:
Payables days
Receivables days
Inventory turnover
Gearing

Question 6

What are the limitations of ratio analysis?

Answer 6

One data set is not enough.

Reliability of data?

Based on the past

Comparability?

Question 7

Why Might Ratio Data Not be Entirely Reliable?

Answer 7

• Financial information involves making subjective judgements.
• Different businesses have different accounting policies
• Potential for manipulation of accounting information (e.g. window-dressing)

Question 8

The Importance of Effective Comparison

Answer 8

One ratio is rarely enough
- Need to compare with competitors
- Need to analyse over time (trends)

Circumstances change over time
- Markets and industries change
- Different economic and market conditions

Question 9

What do ratios not tells you?

Answer 9

• Competitive advantages e.g. brand strength
• Quality
• Ethical reputation
• Future prospects
• Changes in external environment

Question 10

What is gearing?

Answer 10

“Gearing” measures the proportion of a business’ capital (finance) provided by debt.

Question 11

Why is the Gearing Ratio Useful?

Answer 11

The measure of the financial health of a business

Focuses on the level of debt in the financial structure of a business

High gearing can mean high business risk (but not always)

Question 12

What are two ways of measuring gearing?

Answer 12

• Debt/ Equity ratio
• Gearing ratio

Question 13

What is the Capital Structure of a Business?

Answer 13

The capital of a business represents the finance provided to it to enable it to operate over the long term. There are TWO PARTS to the CAPITAL STRUCTURE

Equity: Amounts invested by the owners of the business: e.g share capital, retained profits

Debt: Finance provided to the business by external parties: e.g bank loans, other long-term debts

Question 14

How do you work out gearing ratio?

Answer 14

Non-current liabilities/ Total equity+ non-current liabilities x100

Question 15

What are the capital structure objectives?

Answer 15

Reasons for higher equity in the capital structure
- Where there is a greater business risk (e.g. a startup)
- Where more flexibility is required (e.g. don’t have to pay dividends)

Reasons why high levels of debt can be an objective
- Where interest rates are very low = debt is cheap to finance
- Where profits and cash flows are strong; so debt can be repaid easily

Question 16

Evaluating gearing ratio?

Answer 16

• The gearing ratio of 50% + is normally said to be high
• Gearing of less than 20% is normally said to be low
• But the level of acceptable gearing depends on business & industry

Question 17

What are the benefits of gearing ratio?

Answer 17

• Less capital is required to be invested by the shareholders.
• Debt can be a relatively cheap source of finance compared with dividends.
• Easy to pay interest if profits and cash flows are strong.

Question 18

What are the benefits of the gearing ratio?

Answer 18

• Less risk of defaulting on debts
• Shareholders rather than debt providers “call the shots”
• Business has the capacity to add debt if required

Question 19

What is ROCE?

Answer 19

Return on capital employed

Question 20

ROCE Is a Useful Ratio To…

Answer 20

Evaluate the overall performance of the business.

Provide a target return for individual projects.

Benchmark performance with competitors.

Question 21

How do you calculate ROCE?

Answer 21

Operating profit (or next profit)/ Total equity+ non-current liabilities x 100

Question 22

Evaluating ROCE

Answer 22

ROCE is a widely-used measure of return on investment by businesses

Key points to remember
- ROCE will vary between industries.
- It is based on a snapshot of a business’ balance sheet.
- Comparisons over time and with key competitors are most useful.