ratio analysis


return on capital employed (ROCE)

  • measure of return on investment


  • evaluate the overall performance of the business
  • provide a target return for individual projects
  • benchmark performance with competitors

roce % -  operating profit\ total equity+ non current liabilities x100

evaluating roce

-roce will vary between industries 

-it is based on a snapshot of a balance sheet

-comparisons over time and with key competitors is most useful


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Liquidity ratios- current ratio

liquidity ratios assess whether a business has sufficient cass or equivalent current assets to be bale to pay its debts.

current ratio - current assets\ current liabilities

evaluating the current ratio:

  • a ratio of 1.5 to 2.5 is accceptable liquidity and efficient management of working capital
  • low ratio indicates possible liquidity problems
  • high ratio = too much working capital tied up in inventories or debtors 

for top grade evaluation on current ratio- 

  • industry and market matters- firms have different requirements for holding inventories 
  • how does the current ratio compare with competitors 
  • the trend is more important- a sudden deterioration in current ratio is a good indicatior of liquidity problems
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acid test ratio

acid test ratio - curent assets - stock \ current liabilities 

evaluating acid test ratio

  • a better indictaor of liquidity problems that usually hold inventories
  • less than 1 is often bad news
  • look out for - less relevance for businesses with high stock turnover 
  • trends : significant deterioration in the ratio indicate a liquidity problem.
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gearing ratios

- measures the proportion of a businesses capital provided by debt

gearing ratio %  non-current liabilities\ total equity + non- current liabilities x 100

  • gearing ratio of 50% plus is normally considereed high
  • below 20% is said to be low
  • level of acceptable gearing depends on business and industry

benefits of high gearing -

  • less capital required to be invested by the shareholders
  • -debt is a relatively cheap source of finance compared with dividends.
  • -easy to pay interest if profits and cashflows are strong

benefits of LOW gearing- 

  • less risk of defaulting on debts
  • business has capacity to add debt if required
  • shareholders call the shots rather than debt holders
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ratio analysis-

helps answer questions such as

  • why is one business more profitable than the other?
  • returns from investment?
  • is a business able to stay solvent?

3 main groups of ratios

  • profitability - gross profit margin, operating profit margin, ROCE
  • liquidity - acid test ratio, current ratio
  • financial efficiency- payable days, recieveable days, gearing, inventory turnover

window dressings- a manipulation of financial statements to show more favourable results of the business- used to mislead investors

ratios dont tell you:

  • competititve advantages, quality, ethical reputation, future prospects, changes in external environment
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