Ratio Analysis (Edexcel A Level Business)

An Introduction to Ratio Analysis

• Ratio analysis involves extracting information from financial accounts to assess business performance and answer key questions, including 

  • Why is one business more profitable than another in the same industry?

  • Is a business growing?

  • How effectively is a business using assets and capital invested?

  • What returns on investment are expected?

  • How risky is the financial structure of the business?

 Information Extracted from the Profit & Loss Account and Balance Sheet for Ratio Analysis

• Ratio analysis supports evidence-based decision making, as it provides measurable data that can be used to support judgements and compare performance against objectives

The Ratio Analysis Process

Types of Ratios

The Gearing Ratio

• The gearing ratio shows the long-term financial structure of the business

  • It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used to fund a business

  • The outcome is expressed as a percentage

• The Gearing Ratio is calculated using the formula

• Capital employed can be calculated by subtracting current liabilities from total assets

Return on Capital Employed (RoCE)

• The Return on Capital Employed is also known as the Primary Ratio

• It compares the profit made by a business to the amount of capital invested in the business

• It is a measure how how effectively a business uses the capital invested in the business to generate profit

• Return on Capital Employed is a key performance indicator that can be compared over time and also with competitors and other potential capital investments

• Return on Capital Employed is expressed as a percentage and can be calculated using the formula

Interpreting Ratios to make Business Decisions

The Gearing Ratio

• The Gearing Ratio is used to examine the capital structure of a business

• It compares the amount of capital raised from shareholders with capital raised from loans and other forms of long-term borrowing to show the proportion of business assets that are financed by long-term borrowing

• In short it shows how reliant a business is upon borrowed money

Highly geared business

• In a highly-geared business more than 50 per cent of its capital employed are long-term loans

  • The outcome of the gearing ratio calculation will be greater than 50 per cent

  • Substantial levels of interest will need to be paid on this high level of borrowing which means

    • The level of profit available to pay as dividends to shareholders is reduced

    • Profit available to retain within the business is limited

    • The business is likely to be considered a risk for further investment

    • It is also likely to face difficulties in raising further loan capital 

Steps to reduce the gearing

• A highly-geared business may take steps to lower its ratio by

  • Issuing more ordinary shares to create further share capital

  • Retaining more profits to avoid further borrowing

  • Repaying loans to lower interest costs for the business 

Low geared business

• A low-geared business has less than 50 per cent of its capital employed as long-term loans

  • The outcome of the gearing ratio calculation will be less than 50 per cent

  • The business may be missing out on the opportunity to access finance without the need to dilute existing shareholders' control

  • This is especially true when interest rates are very low as has been the case in the UK over the last 15 years

  • Lenders such as banks are more likely to approve loan applications from low-geared businesses

  • An unwillingness to access loan capital may indicate a risk-averse business which may deter investors

 Steps to increase the gearing

• A low-geared business may take steps to increase its ratio by

  • Buying back ordinary shares to reduce share capital in relation to borrowing

  • Issue more preference shares with limited loss of control

  • Obtain more loans

Interpreting Return on Capital Employed (RoCE)

• RoCE measures how well a business generates profit from the funds invested in the business

• The rate differs between industries so comparison across sectors is not recommended

• However, it can be compared with other forms of return, such as interest rates on savings and with other businesses within the same industry

• RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed

• With RoCE the higher the rate, the better, as it indicates that the business is profitable and using its capital efficiently

  • Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved

  • A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position

• To increase the RoCE level a business can

  • increase the level of profit generated without introducing new capital into the business

  • maintain the level of profit generated whilst reducing the amount of capital in the business

The Limitations of Ratio Analysis

• There are some drawbacks of using ratio analysis which businesses need to be aware of

The Limitations of Ratio Analysis

• Despite these limitations, ratio analysis is used by a wide range of internal and external analysts to assess the performance of companies

• Venture capitalists and other investors use ratios to support their analysis when they consider investing in or lending to businesses

• Banks and insurance providers will use ratios to determine the level of risk a business presents and determine the products to which it may be suited

• Investment analysts and journalists make use of ratio analysis to report to clients and the media in easy-to-digest terms