HideShow resource information

Return on Capital Employed (%) ; Profitbaility

Formula: Operating Profit / Capital Employed X 100

It shows the total resources that a business has available to it. The higher the % the better. And shows how profitable the company is.

How to improve the ratio: 

  • Increase Operating Profit (money earned through operations, doesn't include investment)
  • Reduce value of Capital Employed.
  • Reduce costs.
  • Increase profitable sales.


  • The figure needs to be compared with previous years.
  • Operating Profit figure may include exceptional items e.g. one off large orders.
  • May have large one off costs e.g. the writing off of items.

1 of 11

Current Ratio; Liquidity

Formula: Current assets / Current Liabilities 

It shows how many times a business could pay of its debts in the next year, from their current assets. A ratio between 1.7 and 2.0 is perfect.

How to improve this ratio:

  • Sell off some stock.
  • Reuce time for creditors to pay.
  • Re-pay some of your loans.


  • It is a Crude ratio as it only measure the quantity of the current assets not the quality.
  • Even if the ratio is favourable the firm may be in financial trouble.
  • If the company is in finacial trouble, the true value of assets may not be realised.
2 of 11

Acid Test ratio; Liquidity

Formula: Current assets - Stocks / Current Liabilities

It shows how many times a business can pay debts in the next year from their current assets, not including Stocks.

How to improve ratio: 

  • Reduce time for debtors to pay.
  • Re-pay some of your short term loans/overdrafts.
  • Sell some fixed assets.
  • Increase share capital.


  • Company could have lots of money tied up in inventory that is hard to sell.
  • It ignores timings of both cash received and cash paid out.
3 of 11

Gearing Ratio (%); Liquidity

Formula: long term liabilities / Capital employed X 100

It shows the proportion of capital that is financed through borrowing. A ratio of over 50% is said to high gearing company.

How to improve this ratio:

  • Focus on profit. By doing things such as minimising costs.
  • Issues shares.
  • Retain profits rather than paying dividends to shareholders.


  • Acceptable levels of gearing vary from business to business.
  • Difficult for investor to establish acceptable level of gearing.
  • The higher the gearing the risker the business.
  • High gearing ratios means you are paying out interest rather than retaining it in the business.
4 of 11

Asset Turnover; Financial Effiency

Formula: Revenue / Net assets

It shows the revenue that the business has made using the assets.

How to improve this ratio:

  • Improve revenue.
  • Decrease the amount of assets used to produce the products.


  • There could be exceptional items in the revenue.
  • The assets will depreciate over a given period, changing the asset turnover value.
  • Recently purchased items, might not be working to full capacity. Therefore, not generating expected profit.
  • Doesn't take into account profitability.
5 of 11

Inventory Turnover; Financial Effiency

Formula: Cost of Sales / Average stock held

It shows the number of times a year a firm sells the value of their stock.

How to improve this ratio:

  • Sell off or dispose off slow moving stocks.
  • Introduce lean production to reduce stock holdings.
  • Increase time taken to pay credit.
  • Increase sales from existing stock levels before buying more stock.


  • Irrelevant for businesses in service sector.
  • Difficult to compare with other companies ot in you area.
6 of 11

Creditor Days; Financial Effiency

Formula: Trade payable / cost of sales X 365

It shows the average number of days it takes to pay back pay ables to suppliers.

How to improve this ratio:

  • Improve trade credit from suppliers.
  • Increase the cost of your sales.


  • May lose goodwill from suppliers.
  • Legal action can be taken.
  • Late payments charges.
7 of 11

Debtors Days; Financial Effiency

Formula: Receivables / Revenue X 365

It shows the average number of days it takes to turn receivables into cash.

How to improve this ratio:

  • Offer early payment incentives to customers.
  • Use invoice factoring.
  • Have good credit control facilities.


  • The average time for customers to pay their bills varies.
  • Some customers may move elsewhere if competitors offer better terms of credit.
8 of 11

Dividend Per Share; Shareholder

Formula: Total dividend paid / Number of ordinary shares in issue

It shows the dividend earned per share as a percentage of the share price.

How to improve the ratio: 

  • Reduce the amount of shares. By buying them back.
  • Increase profit.


  • You don't know how much the shareholder initially paid for the share.
  • There may be one off special one-time dividends.
  • If number of shares increase then the ratio changes. 
9 of 11

Dividend Yield; Shareholder

Formula: Dividend Per Share / Share Price X 100

It shows the short term gain of shareholders.

How to improve the ratio:

  • Increasing proportion of profits that are paid out as dividends.
  • Increase profits


  • If figure is poor it may not interest potential investors.
  • If your paying dividends, you don't have the money to invest in other things.
  • Paying dividends reduces value of business.
10 of 11

Limitations to Ratio Analysis

  • Ratios's deal with money, they don't adress issues like product quality or custoer service.
  • Ratios look at the past not the future.
  • Ratios are most useful when they are used to compare performance.
  • Financial infomation can be "window dessed" making compaisons unreliable.
11 of 11


No comments have yet been made

Similar Business Studies resources:

See all Business Studies resources »