Ratio Analysis Flashcards
(19 cards)
What does a gearing ratio show
Shows the proportion of a firms finance that’s from non-current liabilities (long term debt) rather than share capital or reserves (equity)
To work out the gearing ratio, you first have to calculate the capital employed
What’s the formula for capital employed
Non-current liabilities + total equity
You can then calculate the gearing ratio after calculating the capital employed
What’s the formula for gearing ratio
Non-current liabilities / capital employed X100
A gearing above 50% shows what
Shows that over half of a firms finance is from long-term debt (the business is high geared)
A gearing below 50% shows that
Shows that less than half of the finance comes from long-term debt (the business is low geared)
What does gearing show in terms of interest rates
Shows how vulnerable a business is to changes in interest rates.
When a business borrows from the bank, it has to pay interest back to the lender. The amount of interest it has to pay back is determined by interest rates
If a firm has a gearing of 11% - Low geared, what does this tell you
- Tells you most long-term funds come from shareholders or reserves, not borrowing
- Doesn’t want to risk spending too much on interest payments
- As firm doesn’t have to spend profits on interest payments, it can withstand a fall in profits more easily than a highly geared firm - firm can reduce dividend payments to shareholders, unlike loan repayments which have to be made
If a firm has a gearing of 72% - high geared, what does this tell you
- Most long-term funds come from borrowing
- Obvious the firms willing to take risks- if profits fall or interest rates increase, the firms still has to keep up with loan repayments
- might be highly geared to fund growth, or directors don’t want outside shareholders to own a large part of the business
Rewards of high gearing (rewards for borrowing money)
- Extra funds for expansion
- During times of growth, there’s plenty of profit already, so high gearing can be good for business
Risks of high gearing
- May not be able to afford the repayments
- Interest rates could rise, even if at the time of borrowing they were low
Why are shareholders more likely to invest in a highly geared firm
Since high gearing can lead to high profits for firms, shareholders will expect to see large dividends and big increase in share price,
What’s a risk to the shareholder of investing into a highly geared firm
Business may struggle to pay the repayments of the loan and go into liquidation. Therefore, shareholders could lose most or all money they’ve invested into the business
What does return of capital employed analyse
Profitability ratio that’s considered to be the best way of analysing profitability
What’s the formula for return on capital employed (ROCE)
Operating profit / capital employed X100
What does ROCE tell you
How much money is made by the firm, compared to the amount put into the business
E.g. a firm with an ROCE of 10% is making 10p in operating profit for every £1 that’s been put in.
The lower or higher the ROCE the better
The higher the ROCE the better
How can ROCE be improved
- Paying off debt to reduce non-current liabilities
- Or by making the business more efficient to increase operating profit
Advantages of ratio analysis
- Managers can use gearing ratios to decide how to finance growth. If firm is already High geared, it might be better to raise capital through issuing shares, to avoid increasing gearing with more loans
- Potential lenders can use accounting ratios to help them decide if they want to lend to a firm
Limitations of ratio analysis
- Internal strengths, such as quality of staff don’t appear in the figures, so they won’t be In ratios
- Future changes like technological advances or changes in interest rates can’t be predicted by the figures, so won’t show up in the ratios
