Ratio analysis

2017-18

FINANCIAL RATIOS

I Gearing ratio: long-term financial position

I Profitability ratio: shows how well business is doingI Return on capital employed (ROCE): measures profitability of

business

FINANCIAL RATIOS

I Gearing ratio: long-term financial positionI Profitability ratio: shows how well business is doing

I Return on capital employed (ROCE): measures profitability ofbusiness

FINANCIAL RATIOS

I Gearing ratio: long-term financial positionI Profitability ratio: shows how well business is doingI Return on capital employed (ROCE): measures profitability of

business

GEARING RATIOSDEFINITION

I Relationship between

I loans on which interest is paid, andI shareholders’ equity on which dividends might be paid

I Formula:

gearing ratio =non-current liabilities

capital employed× 100%

GEARING RATIOSDEFINITION

I Relationship betweenI loans on which interest is paid, and

I shareholders’ equity on which dividends might be paid

I Formula:

gearing ratio =non-current liabilities

capital employed× 100%

GEARING RATIOSDEFINITION

I Relationship betweenI loans on which interest is paid, andI shareholders’ equity on which dividends might be paid

I Formula:

gearing ratio =non-current liabilities

capital employed× 100%

GEARING RATIOSDEFINITION

I Relationship betweenI loans on which interest is paid, andI shareholders’ equity on which dividends might be paid

I Formula:

gearing ratio =non-current liabilities

capital employed× 100%

GEARING RATIOSDEFINITION

I Relationship betweenI loans on which interest is paid, andI shareholders’ equity on which dividends might be paid

I Formula:

gearing ratio =non-current liabilities

capital employed× 100%

GEARING RATIOSINTERPRETATION

I highly geared: loans are high relative to share capital

I as business gets highly geared:→ creditors consider the business to be more risky

I if gearing ratio ≈ 25%→ business is not overburdened with long-term debt

I if gearing ratio > 50%→ large proportion of business finance is borrowed

I if gearing ratio is low→more finance is provided by shareholders (owners)

GEARING RATIOSINTERPRETATION

I highly geared: loans are high relative to share capitalI as business gets highly geared:→ creditors consider the business to be more risky

I if gearing ratio ≈ 25%→ business is not overburdened with long-term debt

I if gearing ratio > 50%→ large proportion of business finance is borrowed

I if gearing ratio is low→more finance is provided by shareholders (owners)

GEARING RATIOSINTERPRETATION

I highly geared: loans are high relative to share capitalI as business gets highly geared:→ creditors consider the business to be more risky

I if gearing ratio ≈ 25%→ business is not overburdened with long-term debt

I if gearing ratio > 50%→ large proportion of business finance is borrowed

I if gearing ratio is low→more finance is provided by shareholders (owners)

GEARING RATIOSINTERPRETATION

I highly geared: loans are high relative to share capitalI as business gets highly geared:→ creditors consider the business to be more risky

I if gearing ratio ≈ 25%→ business is not overburdened with long-term debt

I if gearing ratio > 50%→ large proportion of business finance is borrowed

I if gearing ratio is low→more finance is provided by shareholders (owners)

GEARING RATIOSINTERPRETATION

I highly geared: loans are high relative to share capitalI as business gets highly geared:→ creditors consider the business to be more risky

I if gearing ratio ≈ 25%→ business is not overburdened with long-term debt

I if gearing ratio > 50%→ large proportion of business finance is borrowed

I if gearing ratio is low→more finance is provided by shareholders (owners)

RETURN ON CAPITAL EMPLOYED (ROCE)DEFINITION

I Compares the profit made with the amount of moneyinvested.

I ”Profit” is defined as operating profit (also known asearnings before interest and tax EBIT)

I Formula:

ROCE =operating profit

capital employed× 100%

RETURN ON CAPITAL EMPLOYED (ROCE)DEFINITION

I Compares the profit made with the amount of moneyinvested.

I ”Profit” is defined as operating profit (also known asearnings before interest and tax EBIT)

I Formula:

ROCE =operating profit

capital employed× 100%

RETURN ON CAPITAL EMPLOYED (ROCE)DEFINITION

I Compares the profit made with the amount of moneyinvested.

I ”Profit” is defined as operating profit (also known asearnings before interest and tax EBIT)

I Formula:

ROCE =operating profit

capital employed× 100%

RETURN ON CAPITAL EMPLOYED (ROCE)INTERPRETATION

I General rule: the higher the ratio the better

I Compare ROCE:

I of the same company over time(e.g., ROCE2013 and ROCE2014)

I of different companies within the same industry

I For investments to be worthwhile:→ ROCE >> return on safe investment

RETURN ON CAPITAL EMPLOYED (ROCE)INTERPRETATION

I General rule: the higher the ratio the betterI Compare ROCE:

I of the same company over time(e.g., ROCE2013 and ROCE2014)

I of different companies within the same industry

I For investments to be worthwhile:→ ROCE >> return on safe investment

RETURN ON CAPITAL EMPLOYED (ROCE)INTERPRETATION

I General rule: the higher the ratio the betterI Compare ROCE:

I of the same company over time(e.g., ROCE2013 and ROCE2014)

I of different companies within the same industry

I For investments to be worthwhile:→ ROCE >> return on safe investment

RETURN ON CAPITAL EMPLOYED (ROCE)INTERPRETATION

I General rule: the higher the ratio the betterI Compare ROCE:

I of the same company over time(e.g., ROCE2013 and ROCE2014)

I of different companies within the same industry

I For investments to be worthwhile:→ ROCE >> return on safe investment

RETURN ON CAPITAL EMPLOYED (ROCE)INTERPRETATION

I General rule: the higher the ratio the betterI Compare ROCE:

I of the same company over time(e.g., ROCE2013 and ROCE2014)

I of different companies within the same industry

I For investments to be worthwhile:→ ROCE >> return on safe investment

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparison

I comparison over time (changing industries)I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)I Qualitative information is ignoredI Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)

I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)I Qualitative information is ignoredI Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)I inter-firm comparison (comparable companies)

I other differences (accounting standards/techniques,methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)I Qualitative information is ignoredI Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)I Qualitative information is ignoredI Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)

I Limitations of the balance sheet (snapshot of a point inyear→ representative?)

I Qualitative information is ignoredI Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)

I Qualitative information is ignoredI Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)I Qualitative information is ignored

I Window dressing

LIMITATIONS OF RATIO ANALYSIS

I Basis for comparisonI comparison over time (changing industries)I inter-firm comparison (comparable companies)I other differences (accounting standards/techniques,

methods for calculation)

I Quality of final accounts (e.g., window dressing)I Limitations of the balance sheet (snapshot of a point in

year→ representative?)I Qualitative information is ignoredI Window dressing