Theme 3.5.2 - Ratio Analysis

Question 1

What is the gearing ratio?

Answer 1

Gearing ratio shows how much of a business’ long-term funding comes from loans compared to money invested by shareholders

Question 2

Why do businesses use a gearing ratio?

Answer 2

Helps them to understand the balance between borrowed money (requires paying interest) and shareholders equity (which may pay dividends)

Question 3

Formula for capital employed

Answer 3

Capital employed = total assets - current liabilities

Question 4

Formula for gearing ratio

Answer 4

(Non-current liabilities/Capital employed) x 100

Question 5

What percentage is considered to be high gearing for a business?

Answer 5

> 50%

Question 6

What does a high gearing ratio mean for a business?

Answer 6

The business depends heavily on loans, higher financial risk as it must make regular interest payments regardless of profits

Question 7

What percentage is considered to be low gearing for a business?

Answer 7

< 50%

Question 8

What does a low gearing ratio mean for a business?

Answer 8

Business relies more on its own funds or shareholders’ equity, generally safer but limits growth opportunities if business avoids taking on debt

Question 9

What are the uses of gearing ratio?

Answer 9

• Assess financial risk: high gearing ratio means relies more on debt which can be risky, lower ratio = lower risk
• Debt decisions: high ratio might limit ability to take on more debt, low ratio gives more room to borrow for growth
• Investor confidence: lower ratio is often seen as safe by investors, making it easier to attract funding
• Cost of borrowing: higher ratio can increase borrowing costs due to higher financial risk
• Expansion plans: business with lower gearing may be able to expand more easily without taking on excessive debt
• Financial stability: gearing helps assess if the business is at risk of struggling with loan repayments

Question 10

What is return on capital employed (ROCE)?

Answer 10

Return on capital employed measures how well a business is using the money it has invested to make a profit. Shows how much profit the business earns for every pound of capital employed

Question 11

Formula for return on capital employed

Answer 11

(operating profit/capital employed) x 100

Question 12

What is capital employed?

Answer 12

Capital employed is the total amount of money being used in the business, which is usually calculated as total assets minus current liabilities

Question 13

What is considered to be a good ROCE?

Answer 13

Depending on the industry, a good ROCE is above 15%

Question 14

What does a good ROCE mean for a business?

Answer 14

A good ROCE means the business is generating returns on its capital that exceed the cost of capital and alternative low risk investment options, such as bank interest

Question 15

What are some uses of ROCE?

Answer 15

• Assess profitability: high ROCE means business is using capital effectively to make profits, low ROCE may show inefficiency and need for improvement
• Investment decisions: strong ROCE attracts investors and helps decide if new investments will provide a good return
• Financing decisions: high ROCE allows business to take on more debt to fund growth, low ROCE might suggest caution