(PAPER 2) 3.5.2 ratio analysis (dk limitations of ratio analysis)

Question 1

gearing definition

Answer 1

gearing is a ratio that shows how reliant a business is on financing through long term debts (e.g. bank loans)

Question 2

gearing ratio formula

Answer 2

gearing ratio (%)= non current liabilities/capital employed x100

Question 3

capital employed definition

Answer 3

the total amount of finance in the business from loans, shares and reserves

Question 4

capital employed formula

Answer 4

capital employed= total equity + non current liabilities

total equity= share capital + retained profits (reserves)

Question 5

interpretations- gearing ratio below 25%

Answer 5

• a gearing level below 25% is known as “low gearing” —> this means that the business is NOT RELIANT on using long term debts for financing and is using other sources of finance instead—–>

this is GOOD because it means that the business wont have large interest payments to make rom its operating profits—–>

HOWEVER it could indicate that the business is risk-averse and is not making full use of opportunities to grow or innovate.—–>

ALSO other sources of finance such as share capital will have their own disadvantages

Question 6

interpretations- gearing ration between 25% and 50%

Answer 6

a gearing ration between 25% and 50% is known as “normal” gearing and many businesses fall into this category——->

this means that the business is not too overly reliant on long term debt and will most likely be spreading its financing across many sources

Question 7

interpretations- gearing ratio above 50%

Answer 7

a gearing ratio above 50% indicates that over half of a firms finance is from long term debts and is known as being “highly geared”
a business that is overly reliant on long term debt as a source of finance is more willing to take risks in order to fund its growth
if profits fall or interest rates rise, the business still has to make loan repayments

• a highly geared business will be more affected by an interest rate rise than a business with low gearing. a business should only be using long term debt for growth and not to fund financial problems ( paying staff or suppliers)

Question 8

interpretations- gearing ratio above 50%

Answer 8

a gearing ratio above 50% indicates that over half of a firms finance is from long term debts and is known as being “highly geared”
a business that is overly reliant on long term debt as a source of finance is more willing to take risks in order to fund its growth
if profits fall or interest rates rise, the business still has to make loan repayments

• a highly geared business will be more affected by an interest rate rise than a business with low gearing. a business should only be using long term debt for growth and not to fund financial problems ( paying staff or suppliers)

Question 9

return on capital employed (ROCE) definition

Answer 9

ROCE is a profitability ratio. it shows how much money is made by the firm, compared to the amount invested into the business

ROCE needs to be compared with the bank of England base rate. this helps investors decide if they’d be better just putting their money in the bank

Question 10

ROCE formula

Answer 10

ROCE (%)= operating profit/capital employed x100

THE HIGHER THE ROCE THE BETTER!!

for example… a business with a ROCE of 10% is making 10p in operating profit for every £1 that’s been invested.

Question 11

THINGS TO KNOW

Answer 11

in the questions showing a graph () do NOT mean -