Ratio analysis

ROCE is a firm's operating profit expressed as a percentage of its capital employed (1) — a measure of how efficiently the business uses the capital invested in it to generate profit (1).

Capital employed = £400,000 + £200,000 = £600,000 (Knowledge 1). ROCE = (£90,000 ÷ £600,000) × 100 = 15% (Application 2). Gearing = (£200,000 ÷ £600,000) × 100 = 33.3% (Analysis 1) — moderate, not highly geared.

A current ratio falling to 0.9:1 means SupplyCo's current liabilities now exceed its current assets (Knowledge + Application). It may therefore be unable to cover its trade payables and overdrafts from its inventory, trade receivables and cash → a serious liquidity problem that could leave SupplyCo unable to pay suppliers or wages on time, disrupting its operations (Analysis).

The sharp decline from 1.8:1 also signals a worsening working-capital position (Knowledge + Application). A rapidly falling ratio suggests SupplyCo is running down cash, over-relying on short-term credit, or holding too little liquid asset → it risks a cash crisis, and lenders and suppliers may lose confidence and tighten terms, tightening the squeeze further (Analysis).

MakerA's higher ROCE is attractive: it shows MakerA generates more operating profit from each pound of capital employed — its factory, machinery and working capital are used more efficiently to produce returns. For an investor seeking profitability, this suggests MakerA is the stronger performer and could deliver better dividends and growth.

However, MakerB's lower gearing matters too. MakerA may have achieved its high ROCE partly by borrowing heavily, which raises financial risk — large interest payments whatever profits are, and exposure to rising interest rates. MakerB, with lower gearing, is financially safer: less debt to service, more resilient in a downturn, and more able to borrow if needed. So MakerA offers higher returns but potentially higher risk; MakerB offers safety but possibly lower returns.

Which is the better investment therefore depends on the investor's attitude to risk and other ratios. A risk-tolerant investor seeking returns may prefer MakerA (higher ROCE), provided its gearing isn't dangerously high; a cautious investor may prefer MakerB's stability. Crucially, two ratios alone aren't enough — the investor should also compare liquidity, margins and multi-year trends, and weigh qualitative factors (order books, plant condition, management). So neither is clearly 'better' on two ratios: MakerA looks stronger on returns and MakerB on safety, and the right choice depends on the investor's risk appetite and a fuller analysis.

A current ratio of 0.8:1 looks alarming on paper, but for a supermarket like RetailCo it needs careful interpretation before concluding it is a real problem.

Why it could be a problem. A ratio below 1 means RetailCo's current liabilities exceed its current assets, so on the face of it, it may struggle to pay trade payables and overdrafts from its liquid assets — a liquidity risk that, if real, could leave it unable to pay suppliers and force costly emergency finance. The bank's concern is understandable.

Why it may not be a problem. However, a low current ratio is normal and often healthy for a supermarket. Supermarkets sell mostly for cash (or fast card settlement) with very high inventory turnover — stock is sold and turned into cash quickly, often before suppliers are paid. So RetailCo continuously generates cash from sales to meet its payables, even with few current assets on the balance sheet at any moment. Holding a 'textbook' 1.5:1 ratio would actually mean cash tied up unproductively. Many successful supermarkets operate below 1:1 deliberately.

Judgement. On balance, RetailCo's 0.8:1 current ratio is probably not the serious problem it first appears, precisely because its supermarket business model — cash sales and rapid inventory turnover — lets it meet short-term debts from ongoing cash flow rather than from balance-sheet current assets. Whether it is genuinely a concern depends on RetailCo's cash flow and inventory turnover: if these are strong and stable (as for a healthy supermarket), the low ratio is fine; if the ratio is falling sharply or its cash generation is weakening, it would become a real warning. So the bank should look at RetailCo's cash-flow trend and how the ratio compares with other supermarkets, not judge it against a generic benchmark. Context — the retail model — is what determines whether 0.8:1 is safe or dangerous.

Ratio analysis is the bank's core tool for judging whether to lend to Apex, but ratios are historical, need context, and miss qualitative factors — so their usefulness depends on how the bank uses them.

Why ratio analysis is useful. Ratios turn Apex's raw financial statements into meaningful, comparable measures. Liquidity ratios (current ratio, acid test) tell the bank whether Apex can meet its short-term debts — directly relevant to repaying a loan. Gearing shows how much Apex already relies on borrowing — vital when deciding whether it can take on more debt safely; a highly geared engineering firm is a riskier borrower. Profitability ratios (margins, ROCE) show whether Apex generates enough profit from its plant and capital to service the loan. Calculated over several years and against rival engineering firms, these ratios give the bank an objective, standardised basis for its lending decision. For assessing creditworthiness, ratio analysis is genuinely powerful.

Its limitations. However, ratio analysis has real weaknesses for judging Apex. Ratios are based on historical statements — they show the past, not whether Apex will prosper over the loan's life, and an engineering firm can be hit by lost contracts, new competition or ageing machinery the ratios don't reveal. A single year's ratios are meaningless without comparison, and different accounting methods and window dressing reduce reliability. Above all, ratios ignore qualitative factors central to a manufacturer's future: the strength of its order book, the condition and productivity of its plant, the reliability of its supply chain, the quality of its management, and the state of its market. Two engineering firms with identical ratios could be very different lending risks.

What it depends on. How useful ratio analysis is for the bank depends on several factors. It depends on using a range of ratios together (liquidity, gearing and profitability) rather than one in isolation — for lending, gearing and liquidity matter most. It depends on comparison — over time and against similar engineering firms, not generic benchmarks. It depends on the quality and honesty of Apex's statements. And, crucially, it depends on whether the bank combines the ratios with qualitative due diligence — the order book, plant, management and market outlook.

Conclusion. On balance, ratio analysis is highly useful but not sufficient for the bank's decision on Apex. It provides an essential, objective framework — especially the liquidity and gearing ratios that reveal whether Apex can safely take on and repay more debt — so the bank is right to rely on it heavily as the backbone of its analysis. But because ratios are historical, dependent on comparison, and blind to the qualitative factors that will actually determine Apex's ability to repay over the loan's life, the bank should treat them as one key input, not the whole decision: using a range of ratios over several years, benchmarking against similar firms, and combining them with qualitative assessment of Apex's order book, plant, management and market. Used that way, ratio analysis is a powerful lending tool; relied on alone, it could lead the bank to lend to a firm that looks healthy on paper but is losing its market. Its usefulness ultimately depends on how comprehensively and alongside what else the bank applies it.