ratio analysis

• measure of return on investment

ROCE IS USEFUL TO-

• evaluate the overall performance of the business
• provide a target return for individual projects
• benchmark performance with competitors

roce % -  operating profit\ total equity+ non current liabilities x100

evaluating roce

-roce will vary between industries 

-it is based on a snapshot of a balance sheet

-comparisons over time and with key competitors is most useful

ROCE IS A WIDELY USED MEASURE OF RETURN ON INVESTMENT BY A BUSINESS.

liquidity ratios assess whether a business has sufficient cass or equivalent current assets to be bale to pay its debts.

current ratio - current assets\ current liabilities

evaluating the current ratio:

• a ratio of 1.5 to 2.5 is accceptable liquidity and efficient management of working capital
• low ratio indicates possible liquidity problems
• high ratio = too much working capital tied up in inventories or debtors 

for top grade evaluation on current ratio- 

• industry and market matters- firms have different requirements for holding inventories 
• how does the current ratio compare with competitors 
• the trend is more important- a sudden deterioration in current ratio is a good indicatior of liquidity problems

acid test ratio - curent assets - stock \ current liabilities 

evaluating acid test ratio

• a better indictaor of liquidity problems that usually hold inventories
• less than 1 is often bad news
• look out for - less relevance for businesses with high stock turnover 
• trends : significant deterioration in the ratio indicate a liquidity problem.

- measures the proportion of a businesses capital provided by debt

gearing ratio %  non-current liabilities\ total equity + non- current liabilities x 100

• gearing ratio of 50% plus is normally considereed high
  
• below 20% is said to be low
• level of acceptable gearing depends on business and industry

benefits of high gearing -

• less capital required to be invested by the shareholders
• -debt is a relatively cheap source of finance compared with dividends.
• -easy to pay interest if profits and cashflows are strong

benefits of LOW gearing- 

• less risk of defaulting on debts
• business has capacity to add debt if required
• shareholders call the shots rather than debt holders

helps answer questions such as

• why is one business more profitable than the other?
• returns from investment?
• is a business able to stay solvent?

3 main groups of ratios

• profitability - gross profit margin, operating profit margin, ROCE
• liquidity - acid test ratio, current ratio
• financial efficiency- payable days, recieveable days, gearing, inventory turnover

window dressings- a manipulation of financial statements to show more favourable results of the business- used to mislead investors

ratios dont tell you:

• competititve advantages, quality, ethical reputation, future prospects, changes in external environment