3.5.2 - Ratio Analysis

What the ratios show

Ratio analysis turns raw accounting figures into something managers, investors and lenders can interpret. In this topic, both ratios start from capital employed, but they ask different questions. Gearing asks how much of the firm's long-term finance comes from borrowing. ROCE asks how much operating profit the business is generating from the long-term finance it uses.

Capital employed matters because it is the denominator in both of the ratios in this lesson.

In exam questions, capital employed can usually be found in one of two ways: non-current liabilities + total equity, or total assets - current liabilities. Once that base is clear, the two ratios become much easier to separate.

The difference matters for judgement. A business can have a reasonable ROCE but still face financial pressure if gearing is high, because interest on borrowing still has to be paid. Equally, low gearing may look safe, but if ROCE is weak the business may not be using its capital efficiently enough to justify future investment.

Calculating gearing and ROCE

The safest method is to calculate capital employed first, then use it in both ratios. That reduces errors because the same denominator appears twice. Remember that ROCE uses operating profit, which means profit before interest and tax, not sales revenue and not profit after all deductions.

Use this small dataset.

That tells us two things straight away. First, the business is below the common 50% high-gearing rule of thumb, because less than half of its capital employed comes from long-term borrowing. Second, it is generating 17.5% operating profit on the long-term finance used. The calculation alone is AO1 and AO2, but the interpretation is what lifts the answer into stronger business analysis.

Using ratios to make decisions

Ratios only become valuable when they change a decision. A high gearing ratio tells managers and lenders that a larger share of the firm's long-term finance comes from borrowing. Because interest must still be paid, a fall in sales or profit can create pressure more quickly. Therefore a highly geared firm may be less able to take on more debt-funded expansion, especially in uncertain markets.

ROCE helps answer a different decision question: is the business earning a worthwhile return from the capital it already controls? If ROCE is rising, managers may feel more confident about investing further because the existing capital base is being used effectively. If ROCE is falling, the business may pause expansion, review efficiency, or question whether too much capital is tied up for too little operating profit.

This is why the two ratios are strongest when read together.