Worked example 1

A bank is deciding whether to lend $500,000 to a retailer. Which financial information and ratios would be most useful? Explain why.

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Liquidity — current ratio and acid test show short-term bill payment ability.

Gearing — debt/equity indicates existing financial risk before new borrowing.

Profitability — ROCE and net margin show whether operations generate sustainable returns to service interest.

Efficiency — inventory days and receivables days — slow turnover may tie up cash.

Cash flow — ability to meet interest cover (PBIT ÷ interest).

Why: Lenders prioritise repayment security, not shareholder growth — historic SOFP/SPL plus trends matter more than marketing data.

Worked example 2

An investor is considering investing in either TechCorp plc or Innovate Ltd. They have the following summarised financial data for the year ended 31 December 2023. Calculate the Return on Capital Employed (ROCE) and the Current Ratio for both companies and advise the investor which company appears to be a better investment based on these metrics.

TechCorp plc:

Profit from operations: $150,000$
Total Equity: $600,000$
Non-current liabilities: $200,000$
Current Assets: $180,000$
Current Liabilities: $90,000$

Innovate Ltd:

Profit from operations: $90,000$
Total Equity: $350,000$
Non-current liabilities: $50,000$
Current Assets: $120,000$
Current Liabilities: $80,000$

Show solution outline

Step 1: State the formulas

ROCE = (Profit from Operations / Capital Employed) x 100
Capital Employed = Total Equity + Non-current Liabilities
Current Ratio = Current Assets / Current Liabilities

Step 2: Calculate Capital Employed

TechCorp plc: $600,000 +$ 200,000 = $800,000$
Innovate Ltd: $350,000 +$ 50,000 = $400,000$

Step 3: Calculate ROCE

TechCorp plc: ( $150,000 /$ 800,000) x 100 = 18.75%
Innovate Ltd: ( $90,000 /$ 400,000) x 100 = 22.5%

Step 4: Calculate Current Ratio

TechCorp plc: $180,000 /$ 90,000 = 2.0 : 1
Innovate Ltd: $120,000 /$ 80,000 = 1.5 : 1

Step 5: Advice to Investor Innovate Ltd has a higher ROCE (22.5% vs 18.75%), indicating it is more efficient at generating profits from its capital. This is a positive sign for an investor seeking strong returns.

TechCorp plc has a higher Current Ratio (2.0:1 vs 1.5:1), suggesting it has a stronger ability to meet its short-term liabilities. This indicates lower short-term risk.

Conclusion: An investor focused on profitability and growth might prefer Innovate Ltd due to its superior ROCE. However, a more risk-averse investor might be attracted to TechCorp plc's stronger liquidity position. The final decision depends on the investor's individual risk appetite and investment strategy.

Users of accounting information — practice questions

Worked example 1

Worked example 2