Financial Analysis - Ratios


Ratios turn financial data from balance sheets and income statements into easy-to-understand numbers. You can use them to compare companies to each other and to assess a company's performance over time

                     Liquidity Ratios show How Much Money is available to Pay the Bills

1) A firm without enough working capital has poor liquidity. It can't use its assests to pay for things when it needs them

2) The liquidity of an asset is how easily it can be turned into cash and used to buy things. Cash is very liquid, non-current assets such as factories are not liquid, and stocks (inventories) and money owed by debtors (receivables) are in between

3) A business that doesn't have enough current assets to pay its liabilities when they are due is insolvent. It either has to quickly find the money to pay them, give up and cease trading, or go into liquidation

4) Liquidity can be improved by decreasing stock levels, speeding up collection of debts owed to the business, or slowing down payments to creditors (e.g. suppliers)

5) A liquidity ratio shows how solvent a business is (how able it is to pay its debts). The main liquidity ratio you need to know is the current ratio

                             Current Ratio = Current Assets / Current Liabilities 

1) The current ratio compares current assets to current liabilities.

    For example, a business with £30,000 of current assets and £32,000 of current liabilities      has a current ratio of: £30,000/£32,000 = 0.9375 (this means that for £1 of liabilities, the       company only has £0.9375 (or 93.75p) of assets, which isn't great, as it means there aren't       enough assets to cover their liabilities)

2) In reality, a business probably couldn't sell off all its stock. It'd also need additional capital to replace stocks - the current ratio should be higher than 1 to take account of this. 1.5 or 2 is considered ideal

3) A value much below suggests a liquidity problem and that it might struggle to meet its current liabilities

                            Return on Capital Employed (ROCE) is a Profitable Ratio

1) A profitablility ratio shows profit margin. The most important profitability ratio is the return on capital employed (ROCE). It's considered to be the best way of analysing profitability and is expressed as a percentage, calculated by:

  • Return on Capital Employed (%) = Operating profit/Total equity + non-current liabilities X100

2) The ROCE tells you how much money is made by the business, compared to how much money's been put into the business. The higher the ROCE, the better

3) It's important to compare the ROCE with the Bank


No comments have yet been made