Ratio Analysis (Edexcel A Level Business)

Revision Note

Written by: Lisa Eades, Business Content Creator

Reviewed by: Steve Vorster, Economics & Business Subject Lead

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

Profit & Loss Account	Balance Sheet
Revenue Cost of Sales Gross Profit Operating Profit Profit for the Year (Net profit)	Current Assets Current Liabilities Inventory (stock) Trade Receivables Trade Payables Long-term liabilities Capital & Reserves

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

Flowchart of financial analysis: Step 1, Collect data; Step 2, Calculate ratios; Step 3, Interpret results; Step 4, Use to make decisions.

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

$Gearing Ratio = \frac{Non Current Liabilities}{Capital Employed} x 100$

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

Worked Example

The table shows an extract from the company accounts of Keals Cosmetics.

Current Assets	£6.2 million
Current Liabilities	£3.4 million
Non-current Liabilities	£9.6 million
Capital Employed	£43.3 million

Calculate the gearing ratio of Keals Cosmetics. (2 marks)

Step 1: Identify the data required to calculate the gearing ratio

Non-current liabilities = £9.6 million

Capital employed = £43.3 million

Step 2: Divide non-current liabilities by capital employed

£43.3 million ÷ £9.6 million = 0.22 (1 mark)

Step 3: Multiple the outcome by 100 and express the result as a percentage

0.22 x 100 = 22% (1 mark)

22% of Keals Cosmetics capital structure is made up of long-term loans

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

$Return on Capital Employed = \frac{Operating Profit}{Capital Employed} \times 100$

Worked Example

The table shows an extract from the company accounts of Keals Cosmetics.

Current Liabilities	£1.5 million
Revenue	£7 million
Total Assets	£15.4 million
Operating Profit	£2.2 million

Calculate Keals Cosmetics' Return on Capital Employed. (3 marks)

Step 1: Calculate the capital employed

$Capital employed = Total assets - current liabilities Capital employed = £ 15.4 m - £ 1.5 m Capital employed = £ 13.9 m$ (1 mark)

Step 2: Divide Operating Profit by Capital Employed

$Return on Capital Employed = \frac{Operating Profit}{Capital Employed} Return on Capital Employed = \frac{£ 2.2 m}{£ 13.9 m} Return on Capital Employed = 0.16$ (1 mark)

Step 3: Multiply the result by 100 and express the outcome as a percentage

0.16x 100 = 16% (1 mark)

The capital employed in Keals Cosmetics has generated a return of 16%

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

Worked Example

Catseye Pressings Ltd is considering making an application for a long-term loan to purchase a new storage facility.

The table shows extracts from its balance sheet.

Non-current Assets	£16.40m
Current Assets	£3.62m
Current Liabilities	£2.18m
Non-current Liabilities	£5.75m

Calculate Catseye Pressings Ltd's gearing ratio and advise whether an application for a loan is likely to be approved on this basis. (5 marks)

Step 1: Calculate the capital employed

$Capital employed = Total assets - current liabilities Capital employed = (£ 16.40 m + £ 3.62 m) - £ 2.18 m Capital employed = £ 17.84 m$ (1 mark)

Step 2: Apply the formula to calculate gearing

$Gearing Ratio = \frac{Non Current Liabilities}{Capital Employed} x 100 Gearing Ratio = \frac{£ 5.75 m}{£ 17.84 m} x 100 Gearing Ratio = 32.23 %$ (2 marks)

Step 3: Identify whether the loan application is likely to be approved

The loan application is likely to be approved (1 mark) as Catseye Pressings Ltd is a low-geared business and thus a relatively low-risk (1 mark) to lenders.

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

Worked Example

Faced with increasing costs Kent & Medway Properties Ltd is looking to close one of its three high street estate agency branches.

The table below shows some key data for each of the branches.

Branch	Capital Employed	Operating Profit
Sevenoaks	£2.4m	£0.37m
Whitstable	£3.1m	£0.57m
Rochester	£2.9m	£0.51m

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on profitability terms, should close. (5 marks)

Step 1: Apply the formula to calculate the RoCE for each branch

$Return on Capital Employed = \frac{Operating Profit}{Capital Employed} \times 100 Return on Capital Employed Sevenoaks = \frac{£ 0.37 m}{£ 2.4 m} \times 100 = 15.42 % (1 mark) Return on Capital Employed Whitstable = \frac{£ 0.57 m}{£ 3.1 m} \times 100 = 18.39 % (1 mark) Return on Capital Employed Rochester = \frac{£ 0.51 m}{£ 2.9 m} \times 100 = 17.59 % (1 mark)$

Step 2: Identify the least profitable branch for closure

Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected for closure. (2 marks)

Examiner Tip

When calculating financial ratios, check that you are using the correct units.

In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases you will be working in thousands (£000) or millions (£m).

Ensure that you convert correctly, e.g. £0.39m is equal to £390,000 and £34.9 (000) is equal to £34,900
Make sure the decimal place is in the correct place
Calculate to two decimal places unless stated otherwise

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

Limitation	Explanation
Making Comparisons	It is important to compare like for like Over time, the nature of a business can change, affecting the desired level of ratio E.g. a business may diversify into a less competitive industry where higher levels of RoCE may be expected Comparisons between firms are only meaningful where significant similarities exist (e.g. same industry, similar size, comparable products) E.g. a high street jewellery business will have very different working capital needs to those of a fast food outlet and their profit margins will differ
Quality of Accounts	Accounts may have been legally window dressed (manipulated) to present a particular financial picture. Examples of this include Bad debts can be written off Property can be revalued Income and costs may be reported during an earlier or later reporting period (e.g. payments to suppliers may be delayed to maximise the level of current assets Window dressing will have an impact on the quality of ratio analysis calculations
Balance Sheet Limitations	As a 'snapshot' of a businesses assets, liabilities and capital at a specific point of time the balance sheet may not be representative of its usual circumstances E.g. a balance sheet may be completed one day before a business sells a large amount of stock or buys a new property, rendering current and non-current assets figures invalid almost immediately
Qualitative Information	As ratios only use numerical data from a businesses accounts key qualitative factors that affect its performance are ignored E.g. the collapse of a competitor may lead to increased sales revenue and profit Increased profit increases the RoCE without any strategic decisions being made

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

Examiner Tip

Calculating ratios is straightforward - the real skill is in the interpretation of results and making recommendations.

If a business is highly-geared, further borrowing is likely to be neither attractive nor possible in most cases. That's quite a simple analytical point.

However, it may be possible to further develop this analysis

For example, in a time of very low interest rates, maximising borrowing to take advantage of cheap finance may be preferable to diluting the control of existing shareholders by issuing further share capital. Now you have evaluation because you've considered both sides of the argument.

If you find evidence in the case study that indicates that shareholders would be unhappy with this dilution of control then you have a balanced, applied piece of evaluation.

Last updated: 25 October 2024

You've read 0 of your 10 free revision notes

Unlock more, it's free!

Join the 100,000+ Students that ❤️ Save My Exams

the (exam) results speak for themselves:

Test yourself Flashcards Next topic

Did this page help you?

Ratio Analysis (Edexcel A Level Business)

Revision Note

An Introduction to Ratio Analysis

Types of Ratios

The Gearing Ratio

Worked Example

Return on Capital Employed (RoCE)

Worked Example

Interpreting Ratios to make Business Decisions

The Gearing Ratio

Worked Example

Interpreting Return on Capital Employed (RoCE)

Worked Example

Examiner Tip

The Limitations of Ratio Analysis

Examiner Tip

You've read 0 of your 10 free revision notes

Unlock more, it's free!

Join the 100,000+ Students that ❤️ Save My Exams

Author: Lisa Eades

Author: Steve Vorster