1. State two examples of a current asset.

2. State the formula for calculating straight line depreciation.

3. What is the formula for Net Assets?
4. What two values must always be equal in a balance sheet?
5. Describe the main difference between a tangible and
intangible non-current asset and provide an example of
both.

Start 5 minutes End

Possible answers include:

1. Cash / Inventory (stock) / Debtors (Receivables)

2. Historic Cost – Residual Value
Useful Life
3. (Fixed Assets + Current Assets) – (Current Liabilities + Non-
Current Liabilities)
4. Net Assets and Shareholders’ Capital (aka. Total Equity)
5. You can touch tangible assets unlike intangible ones which
might include a service or a brand name. A tangible fixed
asset includes land, buildings, vehicles, fixture and fittings
and machinery.
Working capital=
Capital employed=
Shareholders funds (total equity) =
% Change =
Working capital= Current Assets –Current liabilities

Capital employed= Share capital + Retained profit +

Long-term liabilities

Shareholders funds (total equity) = Share

capital + Retained profit

% Change = Difference / Original x 100

WJEC/Eduqas Business A Level
Component Two:
Business Analysis and Strategy
By the end of this topic you should be able to:

• Calculate and interpret return on capital employed (ROCE)

• Calculate and interpret the current ratio and acid test ratio
• Calculate and interpret the gearing ratio (long-term liabilities / capital
employed)
• Analyse the trading, profit and loss account (income statement) and
the balance sheet in order to assess the financial performance of a
business
• Consider business accounts in relation to previous years and other
businesses
• Evaluate the financial position of a business
• Understand that accounts can be affected by window-dressing and
other factors, such as changes in demand and inflation.
Ratios allow comparisons to be made about a firm’s performance.

• This might be in relation to the size of the business or in relation

to the performance of its competitors in the market.

• Ratios help place figures into context and are useful tools in
helping to identify areas of concern or strength.
• Financial ratios are divided up into different categories to help
managers focus their analysis upon particular concepts i.e.
profitability, gearing and liquidity.

Financial
Ratios

PROFITABILITY GEARING LIQUIDITY

Return on Capital
Gearing Ratio Current Ratio
Employed (ROCE)

Acid Test
• ROCE measures the amount of profit made by a firm in
relation to the capital (money) that has been invested.

All stakeholders will be interested in this value as it is a

fundamental measure of business success.

• A low value could harm confidence in the current

management and might result in a falling share value which
makes the company vulnerable to takeover.
In Year 2 of your course, the main profitability ratio used is Return
on Capital Employed (ROCE).

FORMULA

Net Profit X 100

Shareholders’ Funds (Equity) + Long-Term Liabilities#

This is also known as capital employed.

In an exam you can still make use of Net and Gross

Profit Margins to conduct an analysis of a firm’s
profitability.
 Financial Extracts
Item £000
Sales Turnover 650 Net Profit x 100
Capital Employed
Net Profit before Tax 342
Balance Sheet 342,000 x 100
Non-Current (Fixed) Assets 156 325,000 + 74,000 + 255,000

Current Assets 201 = 58.97%

Current Liabilities 193
Share capital + reserves =
Long-Term Liabilities 255
Shareholders’ Equity/funds
Share Capital 325
Reserves 74

This figure is relatively high when compared against low rates of bank interest so
that makes capital investment attractive. However, the returns need to be put into
context. What value have other firms in the same industry achieved? What did the
business themselves achieve last year? Have the business set themselves a target
figure for ROCE and how does this value compare?
 Financial Extracts
Item £000
Sales Turnover 650 Net Profit x 100
Capital Employed
Net Profit before Tax 250
Balance Sheet ? x 100
Non-Current (Fixed) Assets 156 ?+?+?

Current Assets 201 =?

Current Liabilities 193
Share capital + reserves =
Long-Term Liabilities 400
Shareholders’ Equity/funds
Share Capital 300
Reserves 74

This figure is relatively high when compared against low rates of bank interest so
that makes capital investment attractive. However, the returns need to be put into
context. What value have other firms in the same industry achieved? What did the
business themselves achieve last year? Have the business set themselves a target
figure for ROCE and how does this value compare?
Table 3: Financial Extracts for 2016 and 2017
Profit and Loss Account Extracts 2016 2017
£m £m
Net Profit before Interest & Tax 15.63 17.91 THINGS TO CONSIDER:

Balance Sheet Account Extracts 2016 2017 • What has happened to the
£m £m ROCE value?
• Is there anything that might
Long Term Liabilities 97.4 90.23 explain why the value has
Share Capital 105 105 changed?
• How could the ROCE value be
Reserves 24.2 15.6 improved in future years?
Shareholder Funds (Equity) 129.2 120.6 • What don’t we know which
would help us make a better
judgement?
Using Table 3 calculate the return on capital
employed ratio value for both 2016 and 2017
and comment upon the results.
Profit and Loss Account Extracts 2016 2017 Net Profit before Tax x 100
£m £m Capital Employed
Net Profit before Interest & Tax 15.63 17.91
2016
Balance Sheet Account Extracts 2016 2017
£m £m 15.63 x 100 = 6.90%
Long Term Liabilities 97.4 90.23 226.6

Share Capital 105 105 2017

Reserves 24.2 15.6
17.91 x 100 = 8.49%
Shareholder Funds (Equity) 129.2 120.6
210.83

ANALYSIS

The business has seen a rise in their ROCE from 6.90% in 2016 to 8.49% in 2017. One reason for the rise in
the ROCE is that the business has repaid some of their existing long-term liabilities (down from £97.4m to
£90.23m by 2017) and this will help to strengthen their gearing position and limit their exposure to any
rise in interest rates. Further improvements in the ratio value are needed to meet the usually desirable
figure of at least 15% but this is industry dependent, although extra efforts to reduce their long-term
liabilities will help to strengthen the ROCE value even more.
MWB

How can a business

improve there ROCE?
• Reduce capital employed e.g. repayment of debt

• Raise operating profit e.g. reduce supplier costs.

• consider the impact upon quality of this decision.
• firms are likely to be tied-in to a contract with the supplier and to
break this might mean penalty charges.
MWB

Why might a businesses

ROCE be low?
Possible Reasons for Low ROCE

Capital Investment

Economic Downturn

Advertising Campaign
• Liquidity is a measurement of a firm’s cash position at any
given time.
• Low levels of liquidity are one of the most common reasons
for business failure.
• A business should ensure that they hold sufficient cash and
liquid assets to meet their current liabilities.
• Liquid assets are anything that can be easily turned into cash.
• Some Inventories (stocks) are considered to be liquid and
less difficult to change in to cash than others. Depending of
the stage in the production process. However a car
manufacturer would have illiquid stock.
• Inventories might have become obsolete or perished and this
is why they are removed from the calculations when using the
acid test ratio.
• As with all ratios, liquidity ratios must be analysed in context to
be meaningful.

Liquidity assumes greater importance when:

• A firm is experiencing cash flow problems
• A firm has just started trading meaning that short-term solutions to
cash flow problems e.g. overdrafts might not be available
• A business is extending the length of credit offered to its customers
meaning less cash is entering the business
• Stock turnover is low or slowing down

• A strong liquidity position is good but this does not meant that a
business is making a profit. Investors will therefore look at both
the liquidity and profitability ratios.
• Good managers will monitor a firm’s liquidity position
carefully to ensure that the business has enough cash
available to spend to allow it to keep trading.

• The two main ratios used in the measurement of a firm’s

liquidity position are the:

• Current Ratio
• Acid Test Ratio
 Balance Sheet Extract
Item £000 FORMULA The Current Ratio is
Fixed (non-current) Assets 256 a measurement of
Current Assets:
Current Assets the size of a firm’s
Stock 82 Current Liabilities current assets
Cash 60
compared with their
Worked Example current liabilities.
Debtors 59
Total Current Assets 201
Total Assets 457
201,000 = 1.14:1 Ideally firms hold
177,000 1.5 - 2 times more
Current Liabilities 177
current assets than
Long-Term Liabilities 185 current liabilities.
Analysis
Total Liabilities 362

Net Assets 95 This falls below the ideal What information

Shareholders’ Funds (Equity) 95
value of 1.5-2:1. It shows do we need to put
that the business holds this answer into any
£1.14 of current assets sort of meaningful
for every £1 of current context?
liabilities.
• A business can hold too high a level of current assets e.g. more
than twice as many current assets than current liabilities.
• In this situation, a firm is not making the most efficient use of
their resources i.e. they are not making their assets sweat!

Possible reasons for having high levels of current assets:

• Too high a level of cash kept in the bank. It will generate only a
small level of interest. Could be better used if invested.
• A firm allows debtors to increase. This could be bad as many of
these debtors could fail to pay.
• Stock levels rise. This costs a firm money for storage and security.
There is also a risk of the stock perishing or becoming obsolete.
 Balance Sheet Extract
Item £000 FORMULA The Acid Test Ratio
Fixed (non-current) Assets 256 is a more rigorous
Current Assets - Stock assessment of
Current Assets:
Current Liabilities liquidity removing
Stock 82
Cash 60
stock as it takes time
Worked Example to turn into cash
Debtors 59
Total Current Assets 201 201,000 – 82,000 =0.67:1
Ideally firms hold at
Total Assets 457 177,000
least the same level
Current Liabilities 177
of current assets as
Long-Term Liabilities 185 current liabilities 1:1
Analysis
Total Liabilities 362

Net Assets 95 This falls below the ideal What information

Shareholders’ Funds (Equity) 95
value of 1:1. It shows do we need to put
that the business holds this answer into any
£0.67 of current assets sort of meaningful
for every £1 of current context?
liabilities.
• It is important to consider the type
of business when analysing the acid
test ratio.

• A supermarket will turn over stock

very quickly (their stock is highly
liquid) and this means that they will
have a low acid test ratio.

• A car retailer however, will sell very

few cars each week and their stock
is therefore considered to be illiquid
i.e. it takes a long time to turn into
cash.
• Whilst low liquidity levels are a common cause of business
failure they are not necessarily always a problem.
• Some firms can survive with a very low level of liquidity.

How?
• Unlikely that all creditors (current liabilities) will demand their
payments at the same time.
• Successful firms will be able to arrange overdrafts and other
temporary sources of cash.
• Larger firms hold enough power to be able to
delay payments to their creditors until their
own cash flow position improves.
Using Table 1 calculate the Table 1: Financial Summary for 2016
current and acid test ratio
£000 £000
values for 2016 and
comment on the results. Debtors 16
Cash 75
THINGS TO CONSIDER: Stock 26
Current Assets 117
• Ideal liquidity values for both
current and acid test ratios. Creditors 11
• Why are the ratio values so
Overdraft 9
high?
• Is having such a high value a Current Liabilities 20
positive or a negative? Why?
• Evaluate how the results be
made more favourable for this
company?
 £000 £000 Current Ratio Acid Test Ratio
Debtors 16
Current Assets Current Assets - Stock
Cash 75 Current Liabilities Current Liabilities
Stock 26
117,000 = 5.85 : 1 117,000 – 26,000 = 4.55 : 1
Current Assets 117
20,000 20,000
Creditors 11
Overdraft 9 Ideal = 1.5-2.0 : 1 Ideal = 1 : 1
Current 20
Liabilities
ANALYSIS

Given the very high values for both the current ratio (£5.85 of current assets for every £1 of current liabilities)
and the acid test ratio (£4.55 to every £1 of current liabilities), it can concluded that the business is cash rich
and in little danger of experiencing short-term liquidity problems. However, holding so much cash is a
disadvantage as it indicates the business is hoarding cash instead of investing it into new ventures that could
generate higher rates of return than that achieved through keeping the cash in the bank. This risk averse
strategy could mean that the firm miss out on market opportunities and lose market share to more ambitious
rivals. It is important to make their assets sweat (work for them) but we do need to hold more information
about previous years and what the average ratio values are for this particular industry.
• Gearing is a measure of a firm’s total
capital that has been financed through
long-term borrowing (debt finance).

• If a firm is highly geared then they

have borrowed heavily which makes
them vulnerable to a rise in interest
rates as they have to repay more
money back on their debt.

Less than 30% 30-50% More than 50%

LOW GEARED AVG GEARING HIGH GEARED

• If a firm is low geared, much of their capital has come from
shareholders (equity finance).

• This is good in that they don’t have to worry about interest

and debt repayments but bad in that shareholders will want to
see high profits and dividend payments plus have a say in how
the business is being managed on their behalf.
 Capital Employed =
Long-Term liabilities + Shareholders’ Funds

Balance Sheet Extract

The Gearing ratio
Item £000 FORMULA
looks at the long-
Fixed (non-current) Assets 256 Long-Term Liabilities x 100 term debts of the
Current Assets: Capital Employed business in order to
see how the firm
Stock 82
has financed their
Cash 60 Worked Example
assets.
Debtors 59 185,000 x 100 = 66.07%
Total Current Assets 201
280,000 There is no ideal
ratio value but the
Total Assets 457
higher the figure
Current Liabilities 177 the more debt!
Analysis
Long-Term Liabilities 185
Technically the firm is What information
Total Liabilities 362
classed as highly geared. do we need to put
Net Assets 95 However, can it manage this answer into any
Shareholders’ Funds (Equity) 95 its debts? What if sort of meaningful
interest rates rise? context?
• High gearing is not necessarily a problem so long as the
business is able to service their debt (repay on time).

• By not borrowing a business might miss out on opportunities

for future growth and expansion.

Reasons for debt finance include:

• Low interest rates – this makes borrowing attractive
• The owners do not want to lose control through share issues
• The business already has a low gearing ratio
• Bank loans are quicker to acquire than share (equity) capital, to
exploit opportunities or respond to threats in the market.
• A low gearing value indicates that the capital to support the
business has come from sources other than loans.
• The most likely alternative is shareholder capital.
• This makes shareholders a key stakeholder in the business and
this can influence the corporate objectives.
• Shareholders will particularly be looking for a strong financial
performance i.e. profit. This will boost their dividend
payments and ensure a strong market share price.
Evaluation of shareholder capital:
• No interest repayments – there has been no borrowing as shareholder
capital is classified as permanent capital.
• It provides a means of borrowing from banks and other lenders if
needed as they hold very little debt and so carry low risk.
• Low gearing might indicate a reluctance to invest and avoid risk. They
might be missing out on market opportunities because of this.
• The business already have a high gearing ratio so the owners have to
relinquish some control by selling shares to secure additional finance.
Using Table 2 complete the Table 2: Financial Summary for 2016 and 2017
gaps in the table and then 2016 2017
calculate the gearing ratio £000 £000
values for both 2016 and Fixed Assets 545 620
2017 and comment on the Current Liabilities 52 41
results. Long-Term Liabilities 306 350
THINGS TO CONSIDER: Share Capital 94 ?
Financial Reserves 120 91
• What has happened to the
gearing value? Shareholders’ Funds ? 196
• Is there anything that might
explain why the value has
changed?
• Why might the new value
present a possible problem for
the firm?
 2016 2017 ANALYSIS
£000 £000 The business has experienced a rise in their gearing
Fixed Assets 545 670 meaning that they now hold more debt capital which
will need to be repaid plus interest. Given the 6% rise
Current Liabilities 52 41 (58.85% to 64.10%) in borrowings, they are vulnerable
to any rise in interest rates and this also increases
Long-Term Liabilities 306 350 their risk value to banks and investors. However, it
can be seen that their fixed assets have risen and this
Share Capital 94 105
suggests that the borrowings have been used for
Financial Reserves 120 91 reinvestment in the firm which should generate
positive returns in the near future.
Shareholders’ Funds 214 196

2016 2017

Long-Term Liabilities x 100 Long-Term Liabilities x 100

Capital Employed Capital Employed

306,000 = 58.85% 350,000 x 100 = 64.10%

520,000 546,000
Investors and Suppliers Customers
Shareholders

Competitors Employees
Each stakeholder group are interested in looking at the financial
performance of a business for different reasons:

• Investors are primarily interested in the ability of the business to repay

their debts and the value of the dividends that they might receive if the
business does well. (Gearing and shareholder ratios)
• Suppliers will want reassurance that the business has the liquid funds to
pay them (current and acid test ratios)
• Customers might be interested in how long they have to repay their bills
(debtor days)
• Employees will look at the profitability of the business as a sign of job
security and their ability to negotiate pay rises (ROCE ratio)
• Competitors will be seeking to benchmark their performance against
yours to see if they are becoming stronger or weaker in the market.
1. Explain why stock is removed from the Acid Test
Ratio.
2. State which ratio is used to measure profitability.
3. Identify two problems of low gearing.
4. State briefly why holding too high a level of
current assets is a problem for a business.
5. State two means of improving a firm’s ROCE
ratio value.
Start 5 minutes End
Possible answers include:

1. Stock is an illiquid asset / takes time to turn into cash / stock

might be obsolete and value provides a false reading of a
firm’s liquidity position as a result.
2. ROCE / Gross Profit Margin / Net Profit Margin
3. Risk missing out on investment opportunities / shareholder
influence acting upon corporate objectives / focus upon
profits ahead of other objectives / owners hold less control
4. Stock can become obsolete / cash generates only a small
level of interest in the bank / might indicate that the firm
has allowed too many debtors who may not repay!
5. Repay debt (lower capital employed) / reduce costs of
suppliers (raise operating profit)
WE DO
Calculation
GPM
NPM
ROCE
Current ratio
Acid ratio
Gearing
“The results of financial ratio analysis are
outdated as soon as they are published
making them of little use to stakeholders.”
To what extent do you agree with this
statement?
(25 marks)
Points might include some of the following issues:

• Provide a definition of financial ratio analysis and / or stakeholders.

• Consider the benefits of ratio analysis in allowing a detailed financial
analysis of a company’s performance.
• Ratios are historical – much depends upon how quickly the financial
accounts are published.
• The business environment is dynamic and so the results of the ratios
might not provide any indication of what will happen in the future.
• Stakeholders can use ratios to assess management performance in
generating profits and controlling liquidity.
• Ratios allow comparisons to be made between a business and industry
rivals.
• Ratios allow an overview of a company’s performance over time.
• Stakeholders can assess potential problems e.g. liquidity or gearing.
• Ratios should not be used on their own to make decisions.
• Overall, ratios are more useful than not despite being historical.