Ratio Analysis for Decisions: Gearing and ROCE (9BS0 3.5.2)
Edexcel Theme 3 focuses on two ratios: gearing, which measures reliance on borrowed money, and return on capital employed (ROCE), which measures how efficiently capital generates profit. Both are used to assess competitiveness and to judge strategic decisions.
Gearing: formula and meaning
Gearing = (non-current liabilities / capital employed) x 100, where capital employed = total equity + non-current liabilities.
Worked example: a firm has non-current liabilities of £180 million and capital employed of £400 million. Gearing = 180 / 400 x 100 = 45%. Above 50% is conventionally high-geared; below 25% is low-geared.
High gearing magnifies returns to shareholders when profits are strong, and debt interest is a tax-deductible, non-dilutive form of finance. But it raises fixed interest commitments that must be paid regardless of trading. Thames Water shows the danger: with borrowings above £16 billion, interest obligations consumed cash needed for infrastructure, pushing the company to the edge of collapse and forcing bill rises of around 35% by 2030 under Ofwat's December 2024 settlement. Rising interest rates hit high-geared firms hardest when debt is refinanced.
ROCE: formula and meaning
ROCE = (operating profit / capital employed) x 100. It shows the percentage return generated on all long-term funds, whether provided by shareholders or lenders.
Worked example: operating profit of £52 million on capital employed of £400 million gives ROCE = 52 / 400 x 100 = 13%. This should be compared with the firm's cost of borrowing, with previous years and with rivals — a 13% ROCE is strong if competitors earn 8% and loans cost 6%, weak if rivals earn 20%.
Next plc illustrates the top end: it made its first pre-tax profit above £1 billion in the year to January 2025 while running a deliberately capital-light model, producing sector-leading returns on capital. Improving ROCE means raising operating profit (margins, efficiency) or shedding underused capital (selling assets, cutting stock).
Using and criticising the ratios
Together the ratios inform strategic decisions. A board weighing a debt-funded takeover checks whether post-deal gearing stays serviceable and whether the target's ROCE exceeds the interest rate on the new debt — borrowing at 7% to buy 13% returns adds value; the reverse destroys it.
Limitations earn evaluation marks. Ratios are historical: they describe last year, not next. They are distorted by accounting choices (asset revaluations change capital employed overnight) and by sector norms — utilities carry structurally higher gearing than retailers, so cross-sector comparison misleads. A single year's figure says little without trend data; window-dressing near year-end can flatter both ratios. And ratios ignore non-financial strengths such as brand, people and innovation pipeline. Use them as a screening tool that prompts questions, alongside cash-flow analysis and qualitative judgement, rather than as a verdict.
Key terms
Practice questions
Explain one risk to a business of operating with high gearing. [4 marks]
Model answer guidance: High gearing means large fixed interest payments that must be made whatever happens to revenue. If trading weakens or interest rates rise at refinancing, cash is drained from operations and investment. Thames Water, carrying over £16 billion of debt, saw interest obligations absorb funds needed for infrastructure, contributing to its financial crisis. In the worst case the firm cannot service its debt and faces restructuring or insolvency.
Using the data, calculate the gearing ratio and the ROCE of the business. You are advised to show your working. (Non-current liabilities £180m; equity £220m; operating profit £52m.) [4 marks]
Model answer guidance: Capital employed = £220m + £180m = £400m. Gearing = £180m / £400m x 100 = 45%. ROCE = £52m / £400m x 100 = 13%. The firm is moderately geared, just below the 50% threshold, and its 13% return would comfortably exceed typical borrowing costs, suggesting capital is being used effectively.
Discuss how a retailer could improve its ROCE. [8 marks]
Model answer guidance: ROCE rises by increasing operating profit or reducing capital employed. Profit can improve through better margins — trimming discounting, negotiating supplier terms — or higher sales from existing assets, such as extending store opening hours. Capital employed falls by selling underperforming stores, cutting stock levels or leasing rather than owning assets, the capital-light approach behind Next's sector-leading returns and £1 billion profit in the year to January 2025. However, cutting capital too aggressively can starve future growth, and margin improvements may reduce competitiveness, so improvements should target genuinely underproductive capital first.
Assess whether a highly geared business should use retained profit rather than further borrowing to fund expansion. [10 marks]
Model answer guidance: For a firm already above 50% gearing, retained profit avoids adding interest commitments, keeps lenders and credit-rating agencies comfortable, and preserves flexibility if trading turns down. It is also the cheapest source of finance with no issue costs. However, retained profit is limited in size and slow to accumulate, which may delay expansion and let rivals move first; shareholders may also prefer dividends. Borrowing remains rational if the project's ROCE clearly exceeds the interest rate. On balance, a highly geared firm should prioritise retained profit, using modest debt only for projects with returns well above borrowing costs.
Evaluate the usefulness of ratio analysis to a potential investor comparing two plcs. (20) [20 marks]
Model answer guidance: Ratio analysis gives an investor fast, standardised comparison: gearing reveals financial risk, ROCE reveals how productively each board uses capital, and trends over several years expose improvement or decline. Comparing Next's high returns with a heavily indebted utility like Thames Water would immediately flag very different risk profiles. Ratios also discipline the analysis, preventing reliance on narrative alone. However, they are backward-looking, distorted by accounting policies and revaluations, and misleading across sectors with different capital structures. They omit the drivers of future value — brand strength, management quality, innovation — and can be flattered by window dressing. Overall, ratio analysis is a necessary screen but not sufficient: an investor should use it to generate questions, then answer them with cash-flow data, sector context and qualitative research. Its usefulness depends on comparing like with like over time, not on single-year snapshots.
Examiner tips
- Learn both formulas exactly — Edexcel gives no formula sheet, and capital employed = equity + non-current liabilities catches many out.
- Always interpret the number you calculate: compare with 50% for gearing or with borrowing costs and rivals for ROCE.
- In evaluation, mention sector norms and trend data — one ratio in one year proves little.
In The Business School simulation your students make these exact decisions in a live market against rival firms — every choice mapped to the specification. Free teacher demo, no installs, students join with a PIN.