11.6 financial ratios

Question 1

Types of Analysis

Answer 1

• Horizontal, comparing figures within one financial year
• Vertical, comparing figures within different financial years
• Trend Analysis, comparing figures for periods of 3-5 years

Question 2

Analysis of Financial Statements

Answer 2

• Liquidity
• Gearing
• Profitability
• Efficiency

Question 3

Liquidity

Answer 3

• Extent to which a business can meet its financial commitments in short term (less then 12 months)

Question 4

Liquidity: CURRENT RATIO

Answer 4

• Measures ability to pay back current liabilities with their current assets
• Higher the current ratio, the more capable the business is of meeting their short-term obligations
• 2:1 indicates a sound financial position

Question 5

Gearing (Solvency)

Answer 5

• Gearing is the proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business

Question 6

Gearing: DEBT TO EQUITY RATIO

Answer 6

• Extent to which the firm is relying on debt to finance the business
• Ratio of greater than 1 means that the business has less equity than debt
• Ratio of between 0 and 1 means that the business has more equity than debt
• Can be improved by reducing debt or increasing equity

Question 7

Profitability

Answer 7

• Earning performance of the business and indicates its capacity to use its resources to maximise profits
• Gross Profit Ratio
• Net Profit Ratio
• Return on Equity Ratio

Question 8

Profitability: GROSS PROFIT RATIO

Answer 8

• Shows how much each dollar of sales generates profit

Question 9

Profitability: NET PROFIT RATIO

Answer 9

• Shows operating costs or expenses of a business

Question 10

Profitability: RETURN ON EQUITY RATIO

Answer 10

• Shows how effective the funds contributed by the owners have been in generating profit
• The higher the ratio, the better the return for the owner.

Question 11

Efficiency

Answer 11

• Ability of a business to minimise its cost and manage its assets so that maximum profit is achieved with the lowest possible level of assets

Question 12

Efficiency: EXPENSE RATIO

Answer 12

• Shows the amount of sales that are allocated to individual expenses, such as COGs sold and financial expenses

Question 13

Efficiency: ACCOUNTS RECEIVABLE TURNOVER RATIO

Answer 13

• Shows the effectiveness of a firm’s credit policy and how efficiently it collects its debts