Financial Ratios
Business: AQA A Level (2023 Specification), topic 7.2.1
Financial Ratios
The financial performance of a business can be assessed using financial ratios.
Return on Capital Employed
- The return on capital employed (ROCE) calculation allows a business to compare operating profit with the total capital employed by the business.
- ROCE can be calculated using: (operating profit ÷ total capital employed) × 100
- Capital employed can be calculated using: total equity + non-current liabilities.
Current Ratio
- The current ratio calculation allows a business to explore its liquidity by comparing current assets with current liabilities.
- Current ratio can be calculated using:
- Current assets ÷ current liabilities
Gearing calculations
- Gearing calculations can be used to calculate the proportion of long-term funding which comes from debt.
- Gearing can be calculated:
- (Non-current liabilities / capital employed) x 100
Payable days
- Payables days can be used to calculate the time taken for a business to pay those it owes money to.
- Payables days can be calculated:
- (Payables ÷ cost of sales) × 365
Receivables days
- Receivables days can be used to calculate the time taken for a business to collect the money that it is owed.
- Receivables days can be calculated:
- (Receivables ÷ revenue) × 365
Advantages and Disadvantages of Financial Ratios
Using financial ratios to assess performance has both advantages and disadvantages.
Advantages
- Using financial ratios allows a business to compare performance across years.
- Using financial ratios allows a business to compare its performance to competitors but only if their information is available.
Disadvantages
- Using financial ratios does not take into consideration non-financial information such as changes in the external environment.
Example of using financial ratios
- A sole trader may use ratios to calculate performance, but these will not reflect the possible risk of a competitor opening within the next month on the same street.
Test yourself on Financial Ratios
What allows a business to explore its liquidity by comparing current assets with current liabilities?
What is the formula for payable days?
What do financial ratios not take into account?
Which of the following is a non-financial consideration?
Which factor determines whether a business can compare financial ratios with competitors?