Ratio analysis is a key tool used by businesses to evaluate financial performance and competitiveness by examining key figures from financial statements in the form of ratios.
What is ratio analysis?
Ratio analysis is a fundamental part of assessing a business’s performance. It involves the use of data from financial statements to calculate numerical ratios. These ratios allow stakeholders such as investors, managers, and lenders to interpret the financial health and competitiveness of a business. The ratios offer insights into a company’s profitability, efficiency, solvency, and financial stability, which are essential for making informed strategic decisions.
Using ratios helps convert raw data into meaningful comparisons. It allows stakeholders to evaluate whether a business is improving or declining over time, and how it measures up against other companies in the same industry. In this topic, we focus on two key ratios: the Gearing Ratio and Return on Capital Employed (ROCE). These are particularly important when assessing how well a company manages its resources and handles financial risk.
Gearing ratio
Definition
The gearing ratio measures the proportion of a company’s capital that is funded by long-term debt. It is a key indicator of a business's financial risk and its reliance on borrowing. A high gearing ratio suggests that a large proportion of capital has come from loans, whereas a low gearing ratio indicates greater use of equity or internal financing.
Formula
Gearing ratio = (Non-current liabilities ÷ Capital employed) × 100
Non-current liabilities: These are debts and obligations that the business must repay after more than one year. Examples include bank loans, bonds, and debentures.
Capital employed: This is the total amount of capital used for the acquisition of profits. It is calculated as total equity + non-current liabilities.
Interpretation
The result is expressed as a percentage, and different levels of gearing carry different implications:
High gearing (above 50%):
The business has more debt than equity.
This increases financial risk, as the company must make regular interest payments and repay the principal amount regardless of profit levels.
High gearing can be dangerous in periods of falling revenue, as the firm may struggle to meet debt obligations.
However, it also enables faster growth if the borrowed funds are invested wisely, especially in industries that require substantial capital investment (e.g. manufacturing, construction).
Medium gearing (between 25% and 50%):
Represents a balanced approach to financing.
Offers a blend of risk and flexibility.
Low gearing (below 25%):
Indicates the business is less reliant on borrowing.
Lower financial risk and interest costs.
However, the business may be missing out on opportunities to grow through external funding.
Implications for competitiveness
Businesses with high gearing may be seen as riskier by lenders, making it harder to secure additional finance.
Investors might be cautious if the gearing ratio is very high, fearing the possibility of default or instability.
On the other hand, if the business can generate higher returns than the cost of debt, then high gearing can enhance profitability.
The ideal gearing ratio depends on the industry context, the business’s growth strategy, and the level of stable cash flow it can rely on.
Return on Capital Employed (ROCE)
Definition
ROCE is a measure of how efficiently a business is using its capital to generate operating profit. It indicates the return the business earns from every pound invested in the company. This makes it one of the most important profitability ratios used by investors and management.
Formula
ROCE = (Operating profit ÷ Capital employed) × 100
Operating profit: Also known as EBIT (Earnings Before Interest and Tax), this is the profit generated from core business operations before deducting interest and tax expenses.
Capital employed: As above, calculated as total equity + non-current liabilities.
Interpretation
A high ROCE is a sign of strong business performance and indicates that the company is using its capital resources effectively to generate profits.
Low ROCE suggests inefficiency, where too much capital is tied up in assets or where operating profit is weak.
Investors generally prefer businesses with ROCEs higher than the interest rate on loans, and ideally above the industry average.
For example:
A ROCE of 20% means the business earns £20 in operating profit for every £100 of capital employed.
If a company's ROCE falls below 10%, this may trigger concerns about whether the company is achieving sufficient returns to justify its capital use.
Role in investment analysis
ROCE is widely used by investors to assess how well the management is generating profits with the capital at its disposal.
A high ROCE can attract further investment, as it signals strong returns and good potential for dividend payments.
It also helps in identifying underperforming business units, which may require strategic restructuring or divestment.
How businesses use ratio analysis to make decisions
Investment decisions
Ratios like ROCE are crucial for guiding investment in new projects. If expected ROCE from an investment is high, it is more likely to be approved.
Gearing is considered when deciding how to fund expansion—whether to use debt or equity.
Investors use these ratios to decide whether to buy or sell shares in a company, depending on how efficient and financially stable it appears.
Financing decisions
A business with low gearing may choose to raise capital through debt to finance growth without diluting ownership.
Conversely, a highly geared business may try to reduce its debt or avoid additional borrowing to manage financial risk.
Lenders and banks assess gearing and ROCE to determine if the business is creditworthy and capable of repaying loans.
Operational decisions
Management can use ROCE trends to identify inefficiencies in the business.
A falling ROCE may trigger a review of cost structures, asset use, or productivity.
Decisions to automate, restructure, or outsource may be supported by ratio analysis when aiming to boost efficiency.
Strategic planning
Ratio analysis helps in setting strategic goals, like targeting a specific ROCE or maintaining gearing within a safe range.
It supports scenario planning, where businesses model the impact of different strategic options on their financial ratios.
This provides a more data-driven approach to long-term business planning.
Limitations of ratio analysis
Based on historical data
Ratios are calculated from past financial statements, meaning they do not account for recent changes in market conditions or business performance.
For instance, a firm may have had a strong ROCE last year but is currently experiencing a downturn.
Forecasting future performance solely on historical ratios can be misleading.
Susceptible to manipulation
Some businesses may engage in window dressing to make their ratios appear more favourable.
E.g., selling underperforming assets before year-end to boost ROCE.
Delaying expenses to inflate operating profit.
This makes it harder for stakeholders to form a true picture of performance.
Ignores qualitative factors
Ratio analysis doesn’t take into account non-financial elements that are crucial to competitiveness:
Employee morale
Brand value
Customer loyalty
Innovation capabilities
A business might show excellent financial ratios but be suffering from high staff turnover or reputation damage.
Requires contextual understanding
Ratios are most effective when used in comparison:
Over time (trend analysis) to assess improvement or deterioration.
Against industry benchmarks to determine relative competitiveness.
Without context, ratios can mislead rather than inform.
A gearing ratio of 60% may be normal in the utilities sector but excessive in retail.
A ROCE of 12% might be strong in one industry but weak in another.
Best practices when using ratio analysis
Use alongside other financial indicators, such as profit margins, current ratio, and cash flow analysis, to gain a complete view.
Combine with non-financial indicators and qualitative analysis for a holistic understanding of performance.
Regularly update ratio calculations to reflect current financial data and monitor trends over time.
Make decisions using a portfolio of ratios rather than relying on a single measure.
Ensure all ratios are interpreted in context—industry norms, economic environment, and the firm’s strategic goals must be taken into account.
Practice Questions
Analyse how a high gearing ratio might affect a business’s decision to expand operations using additional loan finance.
A high gearing ratio indicates that a significant portion of a business’s capital comes from long-term debt, suggesting high financial risk. If the business already has a high level of borrowing, taking on additional loans to finance expansion could lead to difficulties in meeting interest repayments, especially during periods of low revenue. This may also reduce investor and lender confidence, limiting future funding opportunities. However, if the business has stable cash flows and growth potential, the expansion could still be justified, provided the returns exceed the cost of borrowing and improve profitability in the long term.
Evaluate the usefulness of Return on Capital Employed (ROCE) when assessing the performance of a business.
ROCE is a useful indicator of how efficiently a business is generating profit from its capital. A high ROCE suggests strong performance and can attract investors by signalling good returns. It allows comparisons over time and between firms in the same industry. However, ROCE is based on historical data, which may not reflect current or future conditions. It also ignores qualitative factors like customer satisfaction or innovation. Furthermore, ROCE can be distorted by short-term profit manipulation. Therefore, while useful, it should be interpreted alongside other financial ratios and non-financial indicators for a comprehensive assessment of business performance.
FAQ
Capital employed and total assets are both key figures in financial analysis, but they serve different purposes and are calculated differently. Capital employed refers to the total amount of capital that a business uses to generate profits. It is typically calculated as total equity plus non-current liabilities, or alternatively as total assets minus current liabilities. This figure focuses on the long-term funding of the business and is used in ratios such as ROCE to assess profitability relative to the capital in use.
In contrast, total assets include both current and non-current assets – such as cash, inventory, property, and equipment – without subtracting any liabilities. Total assets represent everything a company owns at a specific point in time. They are used in assessing asset structure and in other ratios like the asset turnover ratio, which is not part of this subtopic. When calculating ratios like ROCE, using capital employed gives a more accurate measure of the long-term resources invested in the business rather than simply the size of the asset base.
A company may choose to maintain a low gearing ratio to minimise financial risk and maintain greater flexibility in decision-making. By relying more on equity than debt, the business avoids the burden of fixed interest payments, which can be particularly important during periods of economic uncertainty or volatile revenue streams. Low gearing also makes a company more attractive to lenders and investors who view it as financially stable and well-managed.
Additionally, a low gearing ratio allows the business to retain control, as taking on more debt often comes with conditions or covenants set by lenders. It can also help the company respond more quickly to opportunities or threats, as it may have unused borrowing capacity available if needed in the future. Furthermore, shareholders may prefer equity-based funding to avoid dilution of ownership and ensure long-term sustainability rather than short-term financial gain. Ultimately, a cautious gearing approach reflects a risk-averse strategy prioritising stability and resilience.
Yes, it is possible for a business to report a high ROCE while still underperforming in other critical areas. ROCE focuses solely on financial efficiency – specifically, how well the business is using its capital to generate operating profit. However, it does not consider the wider context of performance. For example, the company might be achieving high returns through aggressive cost-cutting measures that damage product quality, employee satisfaction, or customer loyalty, which could harm long-term prospects.
Also, ROCE can be temporarily inflated due to one-off events such as asset sales or exceptional income, which do not reflect ongoing business performance. The business might also be heavily reliant on a single product or market, making it vulnerable to changes in demand or competition. Moreover, high ROCE might result from underinvestment in capital, which can hinder future growth. Therefore, while a high ROCE is generally positive, it should be analysed alongside other financial and strategic indicators to assess whether the business is truly competitive and sustainable.
Inflation can significantly distort the interpretation of financial ratios such as ROCE and gearing. Most financial statements are prepared on a historical cost basis, meaning that assets and liabilities are recorded at the value when they were originally acquired. In an inflationary environment, the real value of those assets can be understated, which affects the capital employed figure used in the ROCE calculation. This can lead to an artificially high ROCE, as the denominator (capital employed) is lower than its actual replacement cost in today’s terms.
Similarly, inflation can affect gearing. If the value of assets increases due to inflation but liabilities remain fixed, the proportion of debt to total capital may appear higher than it is in real terms. Inflation can also erode the purchasing power of profits, making it harder for businesses to maintain profitability and repay debts, particularly if revenue doesn't keep pace with rising costs. Therefore, analysts need to be cautious and consider price level changes when using ratio analysis during periods of high inflation.
When comparing businesses across different countries, ratio analysis must be used cautiously due to variations in accounting standards, tax regimes, and economic environments. Different countries may follow different financial reporting frameworks (e.g. IFRS vs US GAAP), which can lead to inconsistencies in how profit, capital employed, and liabilities are recorded. These differences directly affect the calculation of ratios such as ROCE and gearing.
Exchange rate fluctuations can also affect reported figures when converting financial statements into a common currency, introducing currency risk into comparisons. Additionally, interest rates, inflation levels, and lending practices differ across economies, which can make the same gearing ratio appear more or less risky depending on the country. Regulatory requirements, cultural attitudes toward debt, and access to capital markets further complicate direct comparisons. As a result, international comparisons using ratio analysis must be contextualised carefully, and often require adjustments or use of normalised financial data to ensure a fair and accurate evaluation.
