Learning more about the significance of Loans
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By using Ratio Analysis the words in the Balance Sheet and Profit and Loss Account can tell us something about how well the business has performed.
Loans is used in the Gearing (Ratio 11 below) and can therefore tell us something about the investment risk position the business.
The higher the figure the riskier the proposition for a potential ordinary share holder.
Interest payments to debenture holders and dividends to preference share holders , are made out of profits, in priority to ordinary share holders. Whatever is left is available for distribution to ordinary share holders. In a poor year there may not be any profit left over to pay  them. In other words the lower the ratio the better the ordinary share holder position.
Other common ratios are also listed below .
Profitability
1 Return on Capital Employed  =   Profit            x  100 = %
                                                       Capital

2 Gross Profit Ratio                  =   Gross Profit  x  100 = %
                                                            Sales

3 Net Profit Ratio                      =   Net Profit      x  100 = %
                                                           Sales

Efficiency Ratios
4 Stock Turnover Ratio            =  Cost of Goods Sold =  No of times
                                                          Average Stock

5 Fixed Assets Turnover Ratio =  Sales                       = No of times
                                                        Fixed Assets at NBV

6 Debtor Collection Period        =  Average debtors     x 365  = No of days
                                                                   Sales             x   52  = No of weeks
                                                                                         x  12   = No of months

7 Suppliers Payment Period       =    Creditors               x 365   = No of days
                                                          Purchases               x  52    = No of weeks
                                                                                          x  12    = No of months

8 Asset Turnover                       =      Sales                      = No of Times
                                                     Capital Employed

Liquidity Ratios
9 Current Ratio                          =   Current Assets        = Expressed as a
                                                       Current Liabilities        Factor

10 Quick or Acid Test               =  Current Assets - Stock [Also expressed as a Factor]
                                                        Current Liabilities

Investment Ratios
11. Gearing                                 =  Preference Shares + Long Term Loans    X  100%
                                                        Shareholders funds + Long Term Loans
 
 

A Note of caution:
Ratio Analysis is all about comparing one set of ratios with another.
This can mean comparing one year with another, or comparing the performance of one company with another or with its budgets.
To achieve greater confidence in the conclusions you draw, you really need to compare more values than just two. You also need to bear in mind that there is some flexibility in the accounting treatments adopted by accountants when preparing the financial statements and so differences observed in performance might in part be due to differences in the way items have been treated in the accounts rather than differences in performance.
Now test your understanding by attempting to calculate  the gearing ratio from our own figures.
First you need to know whether to examine  the  trading, profit and loss account or the balance sheet.
If you make a mistake you may return here, for another try, by pressing your internet return button. You must return to this point in any event if you wish to take a peep at the answer
 Trading, profit and loss account          Balance sheet

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  answers to the gearing ratio

The gearing ratio is calculated many different ways depending on the reason the user wishes to calculate it. This solution will use one of the straight forward methods.
gearing ratio =   loan                                 x 100 %   =    55     x 100%               =  2.67%
                           loan + capital + profits - drawings         55+ 1,500+!,200-700
 
 This means that the business is low geared. In a high gearing situation there is more risk to owners. This is because owners are only entitled to those profits left over  after loan interest has been paid. If there are large loans then there is more interest to be paid out of profits before leftovers are distributed to owners. A ratio of only 2.67% means the business is a safer bet possibly than a highly geared one.
 return to gearing ratio