Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis

Introduction: Making Sense of the Numbers

Welcome! We are diving into the world of financial ratio analysis. This sounds a bit technical, doesn't it? Don't worry if you find numbers a bit intimidating at first. Think of a business like a professional athlete: to know how healthy they are, you don't just look at them; you check their heart rate, their speed, and their strength.

In Business, ratios are the "health checks" that tell us if a company is winning or if it’s headed for trouble. By the end of these notes, you’ll be able to look at a list of numbers and tell the story of how that business is actually performing. This is a vital part of analysing the strategic position of a business.

1. Prerequisite: Where do the numbers come from?

Before we calculate ratios, we need two main "source documents":

1. The Income Statement: This tells us if the business made a profit or a loss over a period of time (usually a year). Key figures we need: Operating Profit and Revenue.
2. The Balance Sheet (Statement of Financial Position): This is a "snapshot" of what the business owns (Assets) and owes (Liabilities) at a specific moment. Key figures we need: Current Assets, Current Liabilities, Non-current Liabilities, and Capital Employed.

Quick Review: What is Capital Employed?

Capital Employed is the total amount of money put into the business to make it work. It is calculated as:
\( \text{Capital Employed} = \text{Total Equity} + \text{Non-current Liabilities} \)

2. Profitability: Return on Capital Employed (ROCE)

Profitability isn't just about how much money is in the bank; it’s about how efficiently the business uses its resources to generate that money.

The ROCE Formula

\( \text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100 \)

What it tells us: For every £1 put into the business, how many pence of profit are we getting back? If a business has an ROCE of 20%, it means for every £1 invested, they generate 20p in profit.

Analogy: Imagine you put £10 into a lemonade stand and make £2 profit. Your "return" is 20%. If your friend puts £100 into a massive shop and only makes £2 profit, their return is only 2%. You are the more profitable business because you used your money more effectively!

Key Takeaway: Generally, the higher the ROCE, the better. Investors love a high ROCE.

3. Liquidity: The Current Ratio

Liquidity is all about "cash flow health." Can the business pay its short-term bills (like wages or suppliers) on time?

The Current Ratio Formula

\( \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \)

What it tells us: It compares what the business owns that can be turned into cash quickly (Current Assets) against what it owes in the next year (Current Liabilities).

The "Ideal" Result: Most textbooks suggest a ratio of 1.5 to 2.0 is healthy.
- If it’s below 1.0, the business might struggle to pay its bills (it's "illiquid").
- If it’s too high (e.g., 4.0), the business might be "lazy" with its money, perhaps keeping too much cash under the mattress instead of investing it to grow.

Key Takeaway: The current ratio is a test of survival. No cash = no business!

4. Gearing: Assessing Financial Risk

Gearing looks at where the business got its long-term funding from. Did it come from the owners (Equity) or did they borrow it (Debt)?

The Gearing Formula

\( \text{Gearing} = \frac{\text{Non-current Liabilities}}{\text{Capital Employed}} \times 100 \)

What it tells us: The proportion of a business’s capital that is provided by debt.
- High Gearing (Above 50%): The business is funded mostly by loans. This is risky because interest must be paid even if profits are low.
- Low Gearing (Below 25%): The business is funded mostly by its own share capital/profits. This is safer but might mean the business is missing out on growth opportunities that loans could fund.

Memory Aid: Think of "Gears" on a bike. If you are in a "high gear," it takes a lot of effort (interest payments) to keep moving, but you can go very fast (fast growth). If you are in a "low gear," it's easier to pedal, but you move slower.

Key Takeaway: High gearing is risky when interest rates rise or when the economy is struggling.

5. Efficiency Ratios: Managing Resources

These ratios tell us how well the day-to-day operations are being managed. They usually involve Inventory (stock), Receivables (customers who owe us), and Payables (suppliers we owe).

Inventory Turnover

\( \text{Inventory Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}} \)

(Note: AQA usually expresses this as "times per year").
What it tells us: How many times a year the business sells and replaces its stock. A high number usually means the business is efficient and products are flying off the shelves!

Receivables Days

\( \text{Receivables Days} = \frac{\text{Receivables}}{\text{Revenue}} \times 365 \)

What it tells us: How long (in days) it takes for customers to pay their bills.
Goal: Keep this low. You want your money as fast as possible!

Payables Days

\( \text{Payables Days} = \frac{\text{Payables}}{\text{Cost of Sales}} \times 365 \)

What it tells us: How long the business takes to pay its own suppliers.
Goal: Usually, businesses want this to be higher than receivables days. This means you are collecting money from customers before you have to pay your suppliers—great for cash flow!

Did you know? Supermarkets often have very high payables days but very low receivables days. They get your cash instantly at the til but don't pay the farmers for weeks!

6. The Value of Financial Ratios

Calculations are only the first step. To truly assess strengths and weaknesses, we must interpret the data in two ways:

A. Analysis Over Time (Trend Analysis):
Is the ROCE better than it was last year? If the current ratio has dropped from 2.0 to 1.1 in three years, the business is becoming more risky, even if 1.1 is still "okay."

B. Comparison with Other Businesses (Inter-firm Comparison):
A profit margin of 5% might be terrible for a luxury car brand (like Ferrari) but amazing for a supermarket (like Aldi) which relies on high volume and low margins.

Common Mistakes to Avoid:

- Ignoring the context: Don't just say "the ratio is 2.0, which is good." Ask why it is 2.0. Is it because they have too much unsold stock?
- Looking at one ratio in isolation: A business might have high profit (good) but zero cash (bad). Always look at the whole picture.
- Forgetting that data is historical: Ratios tell you what happened last year, not necessarily what is happening today.

Summary Checklist

Quick Review Box:
- ROCE: Efficiency of profit (Higher is better).
- Current Ratio: Ability to pay short-term bills (1.5 - 2.0 is the sweet spot).
- Gearing: Proportion of debt (Above 50% is high risk).
- Efficiency: How fast do we move stock and cash? (Inventory turnover, Receivables days, Payables days).

Don't worry if these formulas seem tricky to memorize at first. Practice calculating them using real company data, and the logic will start to click!