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Accounting and Finance Year 12 ATAR > 16. Ratios > Flashcards

16. Ratios Flashcards

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1
Q

What is the definition of leverage?

A
  • a term used to describe the extent of the borrowings of a business
  • a highly geared business has large interest and loan re-payments and has an increased risk of failure
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2
Q

What is the leverage ratio?

A
  • the debt to equity ratio
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3
Q

What is the definition of the debt to equity ratio?

A
  • measures the extent of the gearing a business
  • the debt-to-equity ratio shows the percentage of company financing that comes from creditors and investors
  • a higher debt to equity ratio indicates that more debt (bank loans) is used than equity (shares)
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4
Q

Describe the interpretation of the debt to equity ratio

A
  • there is no one acceptable figure for the debt to equity ratio
  • a debt to equity ratio of below about 40% would be considered by many investors to be conservative and a debt to equity ratio of more than 100% would be considered to be high
  • it should be noted that the debt level of a company must be considered in relation to the profit made by the company, that is, how the company has used its debt finance to generate income
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5
Q

What is the definition of liquidity?

A
  • the ability of a business to pay its debts as they are due for payment
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6
Q

What are the liquidity ratios?

A
  • working capital / current ratio
  • quick asset ratio
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7
Q

What is the definition of the working capital / current ratio?

A
  • a measure of the ability of a business to pay its short term debts, that is, debts payable within 12 months
  • this ratio means that the business has (%) cents of current assets available to pay every $1 of current liabilities.
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8
Q

Describe the interpretation of the working capital / current ratio

A

<100%:
- indicates either that a business may find it difficult to pay its short term debts or that the business is operating in an industry in which money is collected from sales very quickly
100%-200%:
- indicates that a business should be able to pay its short term debts
>200%:
- indicates that a company should be able to comfortably pay its short term debts or that a company has an excessive level of current assets and is not making the best use of its resources to generate revenue

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9
Q

What is the definition of the quick asset ratio?

A
  • a measure of the ability of a business to pay its short term debts (excluding any bank overdraft) using only its more liquid current assets
  • the inventory and prepaid expenses are left out because they usually have a low level of liquidity
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10
Q

Describe the interpretation of the quick asset ratio

A

There is no one ideal percentage for the quick asset ratio.
<100%:
- indicates that, in an emergency, a business may not be able to pay its short term debts
>100%:
- indicates that a business should be able to pay its short term debts

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11
Q

What is the definition of efficiency?

A
  • evaluate the performance of the management of a company in the areas of inventory and accounts receivable
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12
Q

What are the efficiency ratios?

A
  • debtor’s collection ratio
  • inventory / stock turnover ratio
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13
Q

What is the definition of the debtor’s collection ratio?

A
  • measures how quickly a business collects the money owing from credit sales
  • the gross debtors’ amount is used in the calculation; this is the debtors total before substracting the AFDD
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14
Q

Describe the interpretation of the debtor’s collection ratio

A

An increase in the debtor’s collection period could be caused by any of the following reasons:
- poor debt collecting procedures: this business may not be quickly following up overdue customer accounts
- the slow processing of sales invoices: business may be taking a long time to send out sales invoices to customers
- business may not be checking the credit rating of new customers before selling them products or services on credit
- a business may offer longer credit terms to potential customers to increase sales
A decrease in the debtor’s collection period would indicate that the creditor control and collection procedures have improved.

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15
Q

What is the definition of the inventory / stock turnover ratio?

A
  • measures how many times each year a business replaces its inventory
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16
Q

Describe the interpretation of the inventory / stock turnover ratio

A

An increasing inventory turnover ratio may mean that the products sold by the company (the inventory) are more popular with consumers.
A decreasing inventory turnover ratio may indicate that the inventory management policy of the company is inefficient, that is, the business has ordered too much inventory and may be left with an excessive amount of slow moving or obsolete inventory.

17
Q

What is the definition of profitability?

A
  • a measure of an organisation’s profit relative to its expenses
18
Q

What are the profitability ratios?

A
  • profit ratio
  • rate of return on assets ratio
  • times interest earned ratio
19
Q

What is the definition of the profit ratio?

A
  • shows the percentage of profit after income tax that is contained in each dollar of sales
  • the profit after tax is used as this is the profit available to the shareholders
  • for every $1 of sales made by a business, (%) cents in profit after tax
20
Q

Describe the interpretation of the profit ratio

A

An increase may be caused by:
- a reduction in expenses
- an increase in the selling prices of the products of the company greater than any increase in the cost of sales
- a cheaper supplier of inventory has been found

A decrease may be caused by:
- expense increases that are not being fully passed on to consumers in the form of increased selling prices
- increased competition causing the business to lower its selling prices

21
Q

What is the definition of the rate of return on assets ratio?

A
  • meaures how efficiently a business has used its assets to generate a profit
22
Q

Describe the interpretation of the rate of return on assets ratio

A

An increase in the rate of return on assets ratio may be caused by:
- the company is efficiently using its assets
A decrease in the rate of return on assets ratio may be caused by:
- has not efficiently used its assets to generate revenue

23
Q

What is the definition of the times interest earned ratio?

A
  • the number of times that the interest of a company is covered by the profit before tax
24
Q

Describe the interpretation of the times interest earned ratio

A
  • a widely held view is that a times interest earned ratio of between 3 and 4 times offers a good safety margin for a company
25
Q

What is the definition of market ratios

A
  • used by investors to review the performance of public companies listed on the ASX
26
Q

What are the market ratios?

A
  • earnings per share ratio
  • price / earnings ratio
  • dividend yield ratio
27
Q

What is the definition of the earnings per share ratio?

A
  • the proportion of a company’s annual profit after tax and preference dividends allocated to each issued ordinary share
28
Q

Describe the interpretation of the earnings per share ratio

A

An increase in earnings per share indicates an improvement in profits which would please potential investors
A decrease in earnings per share indicates a decrease in profits which would not please potential investors; can be due to:
- decreasing after tax profits

29
Q

What is the definition of the price / earnings ratio?

A
  • the number of times earnings per ordinary share that an investor is prepared to pay to purchase an ordinary share in the company
30
Q

Describe the interpretation of the price / earnings ratio

A

High price / earnings ratio:
- indicates that investors believe that the future growth in the profit of the company is likely to be very good
- however, this does not mean that this belief is soundly based
- the investors may be over-confident about the future profitability of the company
Low price / earnings ratio:
- indicates that investors believe that the company has poor profit growth prospects
- however, investors may have underestimated the profit potential of the company

31
Q

What is the definition of the dividend yield ratio?

A
  • shows how much a company has paid out in dividends in a year relative to its share price
32
Q

Describe the interpretation of the dividend yield ratio

A

A decrease in the dividend yield ratio indicates that dividends have fallen compared to its share price. Investors would be concerned with such a low dividend yield but may indicate profit retention for future expansion.
A increase in the dividend yield ratio indivates that dividends have rose compared to its share price. Investors will be attracted with a high dividend yield.

Accounting and Finance Year 12 ATAR (16 decks)

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