INTERPRETING FINANCIAL STATEMENTS 85
Return on capital employed (ROCE)
operating profit before interest and tax
shareholders’ funds+long-term debt100
1 , 000 + 300
= 7 .7%
Operating profit/sales
operating profit before interest and tax
sales100
2 , 000
=5%
Gross profit/sales
gross profit
sales500
2 , 000
=25%
Each of the profitability ratios provides a different method of interpreting
profitability. Satisfactory business performance requires an adequate return on
shareholders’ funds and total capital employed in the business (the total of the
investment by shareholders and lenders). Profit must also be achieved as a per-
centage of sales, which must itself grow year on year. The operating profit and
gross profit margins emphasize different elements of business performance.
Liquidity.............................................
Working capital
current assets
current liabilities500
350
=143%
Acid test (or quick ratio)
current assets−inventory
current liabilities500 − 200
350
=86%
A business that has an acid test of less than 100% may experience difficulty in
paying its debts as they fall due. On the other hand, a company with too high a
working capital ratio may not be utilizing its assets effectively.
Gearing..............................................
Gearing ratio
long-term debt
shareholders’ funds+long-term debt