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Summary Ratio Analysis
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Describes gearing ratio (how to interpret it and the advantages/disadvantages of it), and Return on Capital Employed (ROCE)
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Theme 3 Topic 14Ratio Analysis
Gearing Ratio
Gearing Ratio – measures the proportion of a firm’s capital that is financed from long-term borrowing
It is calculated with the formula:
Non-Current Liabilities x 100 Capital Employed = Non-Current Liabilities + Total Equity
Capital Employed
Interpretation of the Gearing Ratio
A sensible target figure is between 25% and 50%
Above 50% is seen as too high as the business has borrowed too much – may have difficulties
repaying loans and will be vulnerable if interest rates increase
Below 25% is seen as possibly too low – the business has not borrowed much as they are relying on
shareholders and retained profits ∴ may have missed out on growth opportunities
Gearing is important when a business is deciding how to finance its expansion:
- E.g. increased borrowing would raise the gearing ratio and expose the business to more risk
- Alternatively, the business could finance expansion through selling more shares, but this may
mean giving up some ownership of the business
Benefits of High Gearing Benefits of Low Gearing
Relatively few shareholders means business owners Less risk from being exposed to more debt
maintain control over decisions and rewards
When interest rates are low, borrowing costs are Reduced borrowing costs if interest rates are high
cheaper
As long as cost of borrowing is lower than May be able to borrow from banks easier as
shareholders dividends the business can retain more business would be considered low risk – able to pay
profit back the loan
Return on Capital Employed (ROCE)
ROCE – measures the amount of profit made by a business in relation to the amount of finance invested i.e. its
capital employed. It uses data from both the Statement of Financial Position and Statement of Comprehensive
Income
It is calculated with the formula:
Operating Profit x 100 Capital Employed = Non-Current Liabilities + Total Equity
Capital Employed
It is a very important ratio as it compares profit to the size of the business so is the main measure of success.
Interpretation of Return on Capital Employed
Businesses want as high a ROCE as possible
A high and rising ROCE indicates that resources are being used efficiently
It should be higher than bank interest rates otherwise it would be more worthwhile investing in the
bank than a business
A good trend would be increasing ROCE and the business wants a higher ROCE than its competitors in
the industry
The Limitations of Ratio Analysis
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