Financial Ratios (AQA A Level Business): Revision Note

An introduction to financial 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?

  • Is the business able to meet its financial obligations?

  • 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 from the financial accounts for ratio analysis

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

The ratio analysis process

Key ratios

Profitability (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

Interpreting ROCE

• The ROCE rate differs between industries so comparison across sectors is not recommended

  • It can be compared with other forms of return, such as interest rates on savings and with other businesses within the same industry

• The higher the ROCE 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

Ways to increase ROCE

1. Make more profit without spending more money

   • If a business earns more money (profit) but doesn't take on extra loans or investment, it will get more return from the same amount of capital

   • Example: A shop sells more products without having to buy new equipment

2. Use less capital to make the same profit

   • If a business keeps profit the same but uses less money overall (e.g. sells off unused equipment or pays off debt), it will be more efficient with what it has

   • Example: A company stops renting a second office and saves money, but still keeps sales and profit steady

The current ratio

• The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio

• All forms of current asset are considered in this ratio

• The current ratio is an effective liquidity measure for businesses that hold little stock

• The result indicates how many £s of current assets it has available to cover each £1 of short term debt

• It is calculated using the formula

• The best way to improve the current ratio is to manage the business better

How to improve the current ratio

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

  • In short, it shows how reliant a business is upon borrowed money

• The gearing ratio is calculated using the formula

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

Interpreting the gearing ratio

Highly geared business

• In a highly-geared business more than 50 percent of the capital employed is long-term loans

  • 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 gearing

• A highly-geared business may take steps to lower its ratio by:

  • Issuing more 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 percent of its capital employed as long-term loans

  • 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 gearing

• A low-geared business may take steps to increase its ratio by

  • Buying back shares to reduce share capital in relation to borrowing

  • Obtain more loans