Financial Ratio Analysis

• What does ROCE stand for?


  Return on Capital Employed
• What does ROCE measure?


  It measures the return a business receives from investing in assets
• How is ROCE calculated?


  ROCE (%) = $\frac{Operating \ Profit}{Total \ Equity + Non-current \ Liabilities} \times 100$
• What does a higher ROCE percentage indicate?


  A higher percentage indicates better performance of the business
• What should be monitored when evaluating ROCE?


  Trends over time and the quality of profit
• What is the liquidity ratio known as?


  Current Ratio
• What does the current ratio assess?


  It assesses whether a business has sufficient cash or equivalent current assets to pay its debts
• What is the formula for the current ratio?

  Current Ratio = $\frac{Current \ Assets}{Current \ Liabilities}$
• What does a current ratio of 2 suggest?


  It suggests efficient management of working capital
• What does a low current ratio indicate?


  A low current ratio indicates cash problems
• What does a high current ratio imply?


  A high current ratio may indicate too much working capital
• What is the acid test ratio formula?


  Acid Test Ratio = $\frac{Current \ Assets - Stock}{Current \ Liabilities}$
• What does the gearing ratio measure?


  It measures the proportion of a business' capital provided by debt
• What is considered a high gearing ratio?


  A gearing ratio greater than 50% is considered high
• Why is the gearing ratio useful?

  It measures the financial health of a business
• What are the benefits of high gearing?


  Less capital is required from shareholders and debt can be cheaper than dividends
• What are the benefits of low gearing?


  Less risk of defaulting on debts and more control for shareholders
• What is the formula for Receivables (Debtor) Days?

  Receivables Days = $\frac{Trade \ Receivables}{Revenue} \times 365$
• What is the formula for Payables (Creditors) Days?

  Payables Days = $\frac{Trade \ Payables}{Cost \ of \ Sales} \times 365$
• What do Receivable Days indicate?


  They indicate the average length of time taken for customers to pay amounts owed
• What do Payable Days indicate?


  They indicate the average length of time taken for a business to pay amounts it owes
• What is the ideal relationship between Receivable Days and Payable Days?


  Payable Days should ideally be higher than Receivable Days
• What does Inventory Turnover measure?


  It measures how often a business sells and replaces its inventory each year
• What is the formula for Inventory Turnover?

  Inventory Turnover = $\frac{Cost \ of \ Sales}{(Average) \ Inventories}$
• What factors could impact inventory turnover?


  Trends, economic climate, competition, promotions, type of inventory, and seasonal demand
• Why is it important to evaluate inventory turnover?


  It varies from industry to industry and can affect customer service and demand fulfillment
• What are the key points to evaluate when analyzing financial ratios?


  • Trends over time
  • Industry norms
  • Quality of profits
  • Comparisons with competitors
  • Balance sheet window dressing
• What are the strengths and weaknesses of high and low gearing?


  Strengths of High Gearing:

  • Less capital required from shareholders
  • Debt can be cheaper than dividends
  • Easy to pay interest if profits are strong

  
  

  Weaknesses of High Gearing:

  • Higher business risk

  
  

  Strengths of Low Gearing:

  • Less risk of defaulting on debts
  • Shareholders have more control

  
  

  Weaknesses of Low Gearing:

  • May limit growth opportunities
• What is one question that ratio analysis helps to answer regarding business profitability?

  Why is one business more profitable than another?
• What is a question that ratio analysis can help determine about a business's viability?

  Is a business able to stay afloat?
• How does ratio analysis assess the efficiency of a business?

  By evaluating how efficiently a business is using its assets
• What does ratio analysis help to evaluate regarding investments in a business?

  What returns are being earned on investment in a business?
• What are the key stages in ratio analysis?

  1. Gather data
  2. Calculate ratios
  3. Interpret results
  4. Take action
• What are the key uses of ratio analysis for different users?

  • Profitability: Shareholders
  • Liquidity: Shareholders, Government
  • Financial Efficiency: Shareholders, Lenders, Competitors, Suppliers
• Who are the primary users of profitability ratios?

  Shareholders
• Which group uses liquidity ratios according to the key uses of ratio analysis?

  Shareholders and Government
• Who primarily uses financial efficiency ratios?

  Shareholders, Lenders, Competitors, Suppliers