15.2 - Ratio Analysis
The gearing ratio and how to calculate it
The gearing ratio measures the proportion of a business's long-term funding that comes from debt, such as loans, compared to equity from shareholders or retained profits. It shows how vulnerable a business is to changes in interest rates.
Formula for gearing ratio
Where:
- Non-current liabilities = Long-term debts (£)
- Capital employed = Non-current liabilities + total equity (£)
Interpreting gearing levels
- High gearing - Above 50%, meaning more than half of funding is from debt. This makes the business more sensitive to interest rate rises, as loan repayments must continue regardless of profits.
- Low gearing - Below 50%, indicating most funding comes from equity. This offers more flexibility, as dividend payments can be adjusted if profits drop.
The amount a business can borrow often depends on its profit levels and the value of assets available as collateral.
Worked example - Calculating gearing ratio
A company has non-current liabilities of £90,000 and total equity of £210,000. Calculate the gearing ratio and determine if the business is high or low geared.
Step 1: Identify the values
- Non-current liabilities = £90,000
- Total equity = £210,000
Step 2: Calculate capital employed
Capital employed = £90,000 + £210,000 = £300,000
Step 3: Apply the gearing ratio formula
Step 4: Interpretation
A gearing ratio of 30% indicates low gearing, as less than half of the funding comes from long-term debt.
Characteristics of high and low gearing
Businesses with different gearing levels have distinct financial profiles, affecting their risk tolerance and operational flexibility.
Features of low gearing
- Most funding comes from shareholders or retained earnings.
- Often reflects a cautious approach to risk.
- Better able to handle profit reductions, as there are fewer fixed loan repayments.
- Can adjust dividend payouts if needed, unlike mandatory interest payments on debt.
Features of high gearing
- Most funding is from borrowing.
- Suggests a readiness to take on risk for potential rewards.
- Requires consistent profits to cover repayments, or assets could be at risk if defaults occur.
- May be used to fuel expansion or keep control away from new shareholders.
From an investor viewpoint, high gearing increases both potential returns (through leverage) and risks. Lenders get interest payments first, while shareholders benefit from any remaining profits but face higher losses in liquidation.
Benefits and risks of borrowing for business growth
Borrowing can provide essential funds for expansion, but it carries risks related to repayment and economic conditions.
Advantages of using debt for expansion
- Supplies additional capital to invest in growth opportunities.
- Can generate profits that exceed the cost of interest and repayments.
- Particularly useful during periods of strong sales, when covering loan costs is easier.
- Helps achieve a competitive edge, such as through new equipment or market entry.
- Allows owners to retain control without issuing more shares.
Risks associated with high levels of debt
- Profits may not be enough to meet repayments, leading to financial strain.
- Exposure to rising interest rates, which increase borrowing costs.
- Risk varies by purpose: borrowing for efficiency gains (e.g., new technology) is less risky than funding day-to-day operations after a sales drop.
- In extreme cases, failure to repay could result in loss of secured assets.
Return on capital employed (ROCE) and its calculation
Return on capital employed (ROCE) is a key profitability ratio that shows how effectively a business uses its invested capital to generate profits. It is often seen as the most reliable measure of overall profitability.
Formula for ROCE
Where:
- Operating profit = Profit before interest and tax (£)
- Capital employed = Non-current liabilities + total equity (£)
Interpreting ROCE
- A higher percentage indicates better performance; for example, 15% means 15p of profit per £1 invested.
- Compare ROCE to interest rates (e.g., Bank of England base rate) to assess if the return justifies the investment.
- Improvements can come from lowering debt levels or boosting efficiency in operations.
Worked example - Calculating ROCE
A business reports an operating profit of £60,000, non-current liabilities of £180,000, and total equity of £220,000. Calculate the ROCE.
Step 1: Identify the values
- Operating profit = £60,000
- Non-current liabilities = £180,000
- Total equity = £220,000
Step 2: Calculate capital employed
Capital employed = £180,000 + £220,000 = £400,000
Step 3: Apply the ROCE formula
Step 4: Interpretation
An ROCE of 15% shows that the business generates 15p of profit for every £1 of capital employed.
Benefits and limitations of ratio analysis
Ratio analysis involves calculating and interpreting financial ratios like gearing and ROCE to evaluate business performance. It has several advantages but also notable drawbacks.
Advantages of using ratios
- Tracks performance trends over multiple periods.
- Highlights areas of financial strength or weakness.
- Guides decisions on funding sources.
- Allows lenders to gauge the safety of providing loans.
- Helps investors compare options across businesses of varying sizes.
Drawbacks of relying on ratios
- Dependent on the accuracy of the original financial data.
- Represents a snapshot at one moment, which may not reflect ongoing changes.
- Ignores qualitative factors, such as employee skills or economic conditions.
- Needs comparison with industry averages for context.
- Does not account for future events like technological shifts or market disruptions.
- Focuses on historical data rather than predictions.
- Can appear negative during heavy investment periods, even if long-term benefits are expected.