Ratio Analysis (3.5.2)

Question 1

What is ratio analysis?

Answer 1

a method used to interpret and evaluate information from a business financial accounts
by comparing different figures within the accounts ratio analysis helps stakeholders understand how well a business is performing an whether its financial position is improving or weakening over time

Question 2

Ratio analysis

Answer 2

ratios are particularly useful as they allow businesses and analysts to compare performances: against previous years to identify trends, against competitors especially those in the same industry and against industry benchmarks

Question 3

Ratio analysis and evidence based decision making

Answer 3

ratio analysis supports evidence based decision making because it provides measurable numerical data that managers and stakeholders can rely on
businesses can make informed judgments about performance rather than relying on assumptions and intuition
also allows performance to be compared against targets past results and competitors helping managers assess whether objectives are being met and where improvements may be needed

Question 4

Ratio analysis steps

Answer 4

collect data - profit & loss account and balance sheet
calculate ratios - return on capital employed and gearing
interpret results - comparison with earlier trading periods and benchmark with competitors
use to make decisions - corporate and functional objectives and strategy & tactics

Question 5

What is gearing ratio?

Answer 5

shows the long term financial structure of a business
measures the proportion of finance that comes from non current liabilities (such as long term loans) compared to the amount provided by shareholders capital

Question 6

Gearing ratio

Answer 6

helps assess how financially risky a business may be
high gearing ratio indicates greater reliance on borrowed finance and has more than 50% of its capital employed as long term loans
low gearing ratio suggests the business is mainly funded through equity and has less than 50% of its capital employed as long term loans
expressed as a percentage

Question 7

Gearing ratio equation

Answer 7

non current liabilities
——————————— x 100
capital employed

Question 8

Capital employed equation

Answer 8

non current liabilities + total equity

Question 9

What is RoCE?

Answer 9

return on capital employed
measures how effectively a business generates profit from the capital invested on it
shows how well the company is using its long term finance to create returns

Question 10

Interpreting RoCE

Answer 10

varies significantly between industries so comparisons across different sectors are not meaningful
useful to compare RoCE with other business within the same industry and alternative forms of return such as interest rates on savings or other investment options
also valuable for strategic decision making, helps managers assess whether to invest further deinvest or choose between different projects based on which options uses capital most profitability
generally the higher the better and shows that the business is both profitable and using its capital efficiently
investors tend to prefer businesses with stable or rising RoCE as this suggests low risk and sustainable growth
20% or more is usually a strong indicator of good financial performance
business can increase RoCE by increasing profit without adding extra capital and reducing capital employed while maintaining the same level of profit

Question 11

Limitations of ratio analysis

Answer 11

making comparisons - over time nature of a business can change which may affect the desired level of a ratio and comparisons between firms are only meaningful when significant similarities exist (such as being in the same industry, of similar size or producing comparable products)
quality of accounts - accounts may sometimes be manipulated to present a particular financial picture which can affect the quality and reliability of ratio analysis because the figures used may not fully reflect the true financial position of the business
statement of financial position - only a snapshot of a business assets liabilities and capital at one specific point in time because of this it may not be representative of the business usual financial position
qualitative information - financial ratios rely solely on numerical data from a business accounts which means important qualitative factors that impact performance are ignored and ratios therefore may give a misleading impression of performance because they do not consider non numerical influences

Question 12

Internal and external stakeholder that rely on ratio analysis to inform their decision making

Answer 12

venture capitalists - use ratios to assess investment potential and lending risk
banks and insurance companies - analyse ratios to judge financial risk and determine which financial products are appropriate for the business
investment analysts and journalists - interpret ratios to produce reports for clients or the media in clear acessible formats