L15: Ratio Analysis

Financial Statements

Businesses produce financial statements to communicate their financial position and performance to stakeholders:

• The statement of financial position (balance sheet) shows what a business owns (assets), owes (liabilities), and what's left for shareholders (equity) at a specific date.
• The income statement shows revenue, costs and profit over a period — typically one year.
• The cash flow statement shows how money actually moved in and out of the business — important because profit doesn't equal cash.

Together, these give stakeholders a complete picture of financial position and performance to assess business health and make decisions.

Categories of Ratio Analysis

Raw financial figures are difficult to interpret without context. Ratio analysis converts them into meaningful measures that can be compared across time and between competitors.

• Profitability ratios (gross/operating/profit-for-year margin, ROCE, ROI) show how efficiently a business converts revenue into profit and how well it uses its capital.
• Liquidity ratios (current ratio, acid test ratio) assess whether a business has enough cash and short-term assets to pay its immediate debts.
• Efficiency ratios (inventory turnover, payable days, receivable days) show how effectively a business uses its assets to generate revenue.

Return on Capital Employed (ROCE)

ROCE measures how efficiently a business converts its invested capital into profit — a key measure of whether management is generating good returns for shareholders.

• ROCE (%) = (Operating profit ÷ Capital employed) × 100.
• Capital employed = Total equity + Non-current liabilities.

For example, a business with £10m operating profit and £50m capital employed has a ROCE of 20% — for every pound of capital employed, it generates 20p of operating profit. ROCE can be compared to the interest rate a business pays on its own borrowing: if ROCE is higher than that rate, the business earns more from its investments than it costs to fund them. Businesses with consistently high ROCE (above roughly 15%) are often market leaders with a real competitive advantage, such as a strong brand or cost advantage. ROCE is a different measure from profit margin: margin shows profit as a percentage of sales, while ROCE shows profit as a percentage of capital invested — a business could have a modest margin but a strong ROCE if it uses its capital especially efficiently, or vice versa.

Gearing

Gearing measures how much a business relies on debt financing relative to equity financing.

• Gearing (%) = Non-current liabilities ÷ (Total equity + Non-current liabilities) × 100.

A business with £5 million of debt and £5 million of equity has 50% gearing. High gearing (above roughly 60%) means the business relies heavily on borrowed money; low gearing (below roughly 30%) means it's primarily financed by shareholders' equity.

High gearing: debt is typically cheaper than equity, interest payments reduce the tax bill, and returns are amplified when profits are strong — but if profits fall, interest must still be paid, which can force cuts to dividends or investment, and high gearing increases the risk of a business going bust.

Low gearing: generally safer, since a business can survive a fall in profits without the pressure of meeting interest payments, and it keeps borrowing capacity available for emergencies — but it may be an inefficient use of capital, since debt could otherwise be used to boost returns, and can signal a lack of growth opportunities to the market.

Return on Investment (ROI)

ROI is a simple but powerful ratio that answers the question: "for every pound we spent on this investment, how much did we get back in profit?" It helps managers decide whether a specific investment was worthwhile.

• ROI (%) = (Profit from the investment ÷ Cost of the investment) × 100.

For example, if a business spends £20,000 on new equipment and this generates an extra £5,000 of profit in its first year, ROI = (£5,000 ÷ £20,000) × 100 = 25% — for every £1 invested, the business earned 25p back in profit. A "good" ROI is always relative: managers compare it to a target ROI they set in advance, to what the money could have earned elsewhere (e.g. in a savings account), or to the forecast ROI of other potential projects.

Advantages: simple to calculate and widely understood; keeps the focus on generating a profitable return; and allows different investment opportunities to be ranked and compared using one clear percentage.

Disadvantages: it can be hard to accurately calculate the exact profit an investment generated; it ignores the timescale of the return, so a 50% ROI over one year looks identical to a 50% ROI over ten years even though they're very different; and it ignores non-financial benefits, such as improved brand reputation or staff morale, that don't show up in the calculation.