Financial Ratios

Liquidity Ratios measure a firm's ability to meet short-term obligations (debts due within one year) using its current assets.

• Current Ratio: Calculated as $\frac{\text{Current Assets}}{\text{Current Liabilities}}$. A ratio of $1.5$ to $2.0$ is often considered healthy, indicating the firm has enough cushion to pay its bills.

Solvency (Gearing) Ratios assess long-term financial stability by looking at the proportion of debt in the capital structure.

• Gearing Ratio: Calculated as $\frac{\text{Non-current Liabilities}}{\text{Capital Employed}} \times 100$. High gearing (e.g., above $50\%$) suggests high risk but potential for high returns, while low gearing suggests a safer, more conservative financial position.

Profitability Ratios evaluate how effectively a business generates profit relative to its size or investment.

• Return on Capital Employed (ROCE): Calculated as $\frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100$. This is a primary measure of how efficiently management uses all available capital to generate earnings.

Efficiency Ratios (Activity Ratios) track how quickly a business converts its assets into cash or sales.

• Inventory Turnover: Measures how many times a year a company sells and replaces its stock. A higher number usually indicates strong sales and effective stock management.

• Receivable Days: Calculated as $\frac{\text{Receivables}}{\text{Revenue}} \times 365$. It shows the average time taken to collect cash from customers who bought on credit.

• Check the Units: Always verify if the answer should be a percentage (like ROCE or Gearing), a ratio (like 2:1), or a number of days (like Receivable Days).

• Consistency in Data: When calculating turnover ratios, ensure you use the correct denominator (e.g., use Cost of Sales for inventory turnover, but Revenue for receivable days).

• The 'So What?' Factor: In exams, calculating the ratio is only half the task. You must interpret what the change means (e.g., 'A rising gearing ratio increases the risk of insolvency if interest rates rise').

• Sanity Check: If a current ratio comes out to $0.02$ or $500$, re-check your decimal places and units; most healthy businesses operate within a much narrower range.