3.5.2 Ratio Analysis

Ratio Analysis

Finding relationships between financial data to assess the performance of the business.

Liquidity Ratios

• Identifying the short-term financial stability of a firm by examining whether there are sufficient short-term assets to meet the short-term liabilities.

$$Current ratio = Current assets/Current liabilities$$

📌 Ideal current ratio = 1.5-2:1

---

$$Acid test ratio = (Current assets – Stock)/Current liabilities$$

📌 Ideal acid test ratio = 1.1-1.5 : 2

Profitability Ratio

• Assess a business's ability to generate earnings compared to its expenses during a specific period of time.

Return on Capital Employed (ROCE)

The profit made by a business as a percentage of the total amount of money invested

$$Capital employed = Non-current liabilities + Total Equity$$

Net assets = Total Equity

• The higher the ROCE, the better

Gearing Ratio

• Examining how dependent a business's total value is on borrowed money affects the company's long-term financial position.

• The higher the gearing (level of borrowing), the higher the risk to the business due to higher interest repayments.
• However, gearing can be a financially sound part of a business's capital structure, particularly if the business has strong, predictable cash flows.

Limitations of Ratio Analysis

• Difficult to compare over time if the nature of the business has changed
• Only useful if the financial accounts are accurate
• The balance sheet is a snapshot, so different days may show different results
• Only relies on quantitative information (not qualitative information such as customer service and employee morale)
• Window dressing (made to look good) affects the appearance of accounts