Ratio Analysis

Question 1

Define RATIO ANALYSIS

Answer 1

Ratio analysis is an examination of accounting data by relating one figure to another. This allows for more meaningful interpretation of the data and the identification of trends.

Question 2

What are the three key types of ratio?

Answer 2

1. Liquidity ratios - current ratio and acid test ratio
2. Profitability margins - gross profit, operating profit, net profit and ROCE.
3. The gearing ratio

Question 3

Define RETURN ON CAPITAL EMPLOYED

Answer 3

ROCE measure how much profit is made by a business compared to how much capital has been invested.

Question 4

What is the formula for ROCE?

Answer 4

ROCE = (operating profit/capital employed) x 100

Question 5

How can low ROCE be improved?

Answer 5

• Increasing long term profit, without increasing loans.

- Repaying some long term loans, which then reduces capital employed

Question 6

What should ROCE be compared to?

Answer 6

• ROCE from previous years
• ROCE of competitors
• Current base rate of interest

Question 7

Define the GEARING RATIO

Answer 7

The gearing ratio measures the percentage of total capital employed in a firm that comes from long term loans (non-current liabilities).

Question 8

What is the formula for gearing?

Answer 8

Gearing = (non current liabilities/capital employed) x 100

Question 9

Define HIGHLY GEARED

Answer 9

A business is said to be highly geared if more than 50% of its total capital employed exists in the form of loans.

Question 10

Define LOWLY GEARED

Answer 10

A business is said to be lowly geared if less than 25% of its total capital employed exists in the form of loans.

Question 11

What are the features of a highly geared business?

Answer 11

• Vulnerable to changes in interest rates
• Shows that a firm is willing to take risks
• Difficulty keeping up with loan repayments if profit falls.
• Risky in a slow economy as payment will still need to be made.

Question 12

What are the features of a lowly geared business?

Answer 12

• Shows the business may be risk averse and therefore they miss out on growth opportunities.
• Will have less difficulty repaying loans if profit falls.
• Can take out additional loans to fund new projects if necessary.
• Less risky when the economy is slowing down.

Question 13

What are the limitations of ratios?

Answer 13

• Need to be compared over a period of time to get an idea of trends.
• Only as reliable as the documents they are based on.
• Comparison with competitors is needed to get industry context and identify which factors can be controlled by the business and which affect all businesses.
• Qualitative factors are ignored
• Product portfolio and product development are ignored.
• External economic factors or changes in a firm’s competitive environment are not reflected in statements.