Analysis of Ratios (Cambridge International A-Level Accounting)

Spec point — how to analyse and evaluate the results of the ratios and draw conclusions how to make appropriate recommendations to stakeholders on the basis of the analysis undertaken the interrelationships between ratios

Analysis of ratios

How do I evaluate information from accounting ratios?

• STEP 1 State the value of the ratio

  • You might have to calculate this from data
  • Make sure you include the correct units (%, times or days)

• STEP 2 State whether the ratio has improved or worsened

  • You might have to compare:

    • two businesses
    • two years for the same business
    • one year with the industry average

• STEP 3 Give a possible reason for the change

• STEP 4 State the implication or give a recommendation

  • You might have to explain how the result impacts the business
  • Or you might have to suggest what action should be taken

Exam Hint Always show your working when calculating a ratio. You can get marks for using your own figures, mark schemes refer to these marks as OF.

Worked Example David recently inherited $50 000 and wants to invest it in ordinary shares. He is considering two companies in the same industry: Alpha plc and Beta plc.

David has two main investment objectives:

1. He wants to earn a steady and high regular income from his investment.
2. He is risk-averse and wants to invest in a company that is considered low risk.

The following information has been extracted from the financial statements of both companies for the year ended 31 December 2025.

	Alpha plc ($)**	Beta plc ($)
Ordinary share capital	400 000 ($1 shares)	300 000 ($0.50 shares)
Retained earnings (after the year's profit)	250 000	150 000
8% Debentures (2030)	100 000	-
10% Debentures (2028)	-	300 000
Profit for the year	95 000	60 000
Dividends paid during the year	19 000	45 000

The market price of one ordinary share at 31 December 2025 was $2.85 for Alpha plc and $0.80 for Beta plc.

(a) Calculate the following ratios for both Alpha plc and Beta plc for the year ended 31 December 2025:

(i) Gearing ratio (two decimal places)

(ii) Earnings per share (EPS) (two decimal places)

(iii) Price/earnings (P/E) ratio (nearest whole number)

(iv) Dividend yield (two decimal places)

(b) Advise David which company he should invest in to meet his objectives. Justify your answer using the ratios calculated in (a).

Answer:

(a)

(i) Gearing ratio: $\frac{\mathrm{Fixed} \mathrm{cost} \mathrm{capital}}{\mathrm{Total} \mathrm{capital}}\times100$

Alpha plc: $\frac{100 000}{400 000 + 250 000 + 100 000} \times 100 = 13.33 \%$

Beta plc: $\frac{300 000}{300 000 + 150 000 + 300 000} \times 100 = 40.00 \%$

(ii) Earnings per share (EPS): $\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Number} \mathrm{of} \mathrm{issued} \mathrm{ordinary} \mathrm{shares}}$

Alpha plc: \frac{95 000}{400 000} = \ 0.24 \text{per} \text{share}$

Beta plc: \frac{60 000}{600 000} = \ 0.10 \text{per} \text{share}$

(iii) Price/earnings (P/E) ratio: $\frac{\mathrm{Market} \mathrm{price} \mathrm{per} \mathrm{share}}{\mathrm{Earnings} \mathrm{per} \mathrm{share}}$

Alpha plc: $\frac{2.85}{0.24}=12$

Beta plc: $\frac{0.80}{0.10}=8$

(iv) Dividend per share: $\frac{\mathrm{Annual} \mathrm{ordinary} \mathrm{dividend}}{\mathrm{Number} \mathrm{of} \mathrm{issued} \mathrm{ordinary} \mathrm{shares}}$

Alpha plc: \frac{19 000}{400 000} = \ 0.0475$

Beta plc: \frac{45 000}{600 000} = \ 0.075$

Dividend yield: $\frac{\mathrm{Dividend} \mathrm{per} \mathrm{share}}{\mathrm{Market} \mathrm{price} \mathrm{per} \mathrm{share}}\times100$

Alpha plc: $\frac{0.0475}{2.85} \times 100 = 1.67 \%$

Beta plc: $\frac{0.075}{0.80} \times 100 = 9.38 \%$

(b)

Beta plc has a significantly higher dividend yield (9.38%) compared to Alpha plc (1.67%). Therefore, Beta plc will provide David with the high regular income he is seeking. However, Beta plc distributes a very large portion of its profits as dividends ($45k out of $60k), meaning its dividend cover is low, which could threaten future dividend payouts if profits fall.

Alpha plc is much lower risk because its gearing ratio is only 13.33%, which is considered very low-geared. Beta plc has a gearing ratio of 40%, which is much closer to the 50% high-risk threshold, meaning a large portion of its profits will be consumed by fixed interest payments. Furthermore, Alpha plc has a higher P/E ratio (12) compared to Beta plc (8), indicating that the market has higher confidence in Alpha plc's future growth and stability.

David faces a conflict between his two objectives. He should invest in Beta plc if his need for immediate high income is his absolute priority, but overall, he should invest in Alpha plc because its low gearing aligns perfectly with his risk-averse nature.

What are the interrelationships between ratios?

• Ratios affect each other
• The table shows examples of how they interact

• Multiple ratios can interact

  • For example, suppose a business gains more debt

    • This raises the gearing ratio

  • It then has to pay more interest

    • This lowers the interest cover

  • It then has a lower profit after interest and tax

    • This lowers earnings per share and dividend cover

Which ratios do stakeholders look at?

• Different stakeholders are interested in different ratios

Worked Example The directors of M plc are reviewing the company’s financial performance for the year ended 31 December 2025. They want to compare their results against their main competitor, N plc, to assess their market position.

The following ratios have been calculated for both companies for the year ended 31 December 2025:

Ratio	M plc	N plc
Working capital cycle	78 days	42 days
Gearing ratio	62%	25%
Interest cover	2.5 times	8.2 times
Price/earnings (PE) ratio	6	15
Dividend yield	9.2%	3.5%

Evaluate the performance and position of M plc compared to N plc in respect of:

(i) working capital management

(ii) solvency and risk

(iii) investor confidence and returns.

Answer:

(i) Working capital management

M plc takes significantly longer to convert its net working assets into cash (78 days) compared to N plc (42 days). This indicates that M plc is less efficient at managing its working capital.

It suggests that M plc may be holding too much inventory for too long, or has poor credit control leading to a longer trade receivables turnover period compared to N plc. Consequently, M plc may face tighter liquidity/cash flow problems than its competitor.

(ii) Solvency and risk

M plc is highly geared (62%), well above the 50% threshold, whereas N plc is low-geared (25%). This means M plc relies heavily on external borrowing rather than shareholder equity, making it a much higher-risk investment than N plc.

M plc has a much lower interest cover (2.5 times) than N plc (8.2 times). This shows that a large proportion of M plc's profit from operations is consumed by finance costs, making it more vulnerable if profits fall, as it may struggle to pay its interest obligations.

(iii) Investor confidence and returns

M plc has a much lower PE ratio (6) than N plc (15). This indicates that the stock market has less confidence in M plc and expects lower future earnings growth compared to N plc.

However, M plc offers a much higher dividend yield (9.2%) compared to N plc (3.5%). This suggests M plc is paying out a large proportion of its earnings to shareholders, making it attractive to investors seeking immediate regular income rather than long-term capital growth.