3-5-2-ratio-analysis

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An introduction to ratio analysis

Ratio analysis involves extracting information from financial accounts to assess business performance and answer key questions, including:
- Why is one business more profitable than another in the same industry?
- Is the business growing?
- How effectively is the business using its assets and capital invested?
- What returns on investment are expected?
- How risky is the financial structure of the business?

Information extracted from the statement of comprehensive income and the statement of financial position for ratio analysis

Statement of comprehensive income	Statement of financial position
Revenue Cost of sales Gross profit Operating profit Profit for the year (net profit)	Current assets Current liabilities Inventory (stock) Trade receivables Trade payables Long-term liabilities Capital and reserves

Ratio analysis supports evidence-based decision-making, as it provides measurable data that can be used to support judgements and compare performance against objectives

The ratio analysis process

Flowchart of financial analysis: Step 1, Collect data; Step 2, Calculate ratios; Step 3, Interpret results; Step 4, Use to make decisions. — **The ratio analysis process involves collecting data, calculating ratios, interpreting results and then using results to make decisions**

Types of ratios

Gearing ratio

The gearing ratio shows the long-term financial structure of the business
- It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used to fund a business
- The outcome is expressed as a percentage

The gearing ratio is calculated using the formula

$Gearing space Ratio space equals fraction numerator space Non space Current space Liabilities over denominator Capital space Employed end fraction space straight x space 100$

Capital employed can be calculated by adding non-current liabilities to total equity

Worked Example

The table shows an extract from the company accounts of Keals Cosmetics.

Current Assets	£6.2 million
Current Liabilities	£3.4 million
Non-current Liabilities	£9.6 million
Capital Employed	£43.3 million

Calculate the gearing ratio of Keals Cosmetics.

(2)

Step 1: Identify the data required to calculate the gearing ratio

Non-current liabilities = £9.6 million
Capital employed = £43.3 million

Step 2: Divide non-current liabilities by the capital employed

$equals space £ 43.3 space million space divided by space £ 9.6 space million equals space space 0.22$ (1)

Step 3: Multiply the outcome by 100, and express the result as a percentage

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