18. Ratio Analysis

Question 1

<p>How is Gearing Ratios defined?</p>

Answer 1

<p>Exploration of the capital structure of the business by comparing the proportions of capital raised by debt and equity.</p>

Question 2

<p>How is Profitability or Performance Ratio defined?</p>

Answer 2

<p>Illustration of the relative profitability of a business.</p>

Question 3

<p>How is Ratio Analysis defined?</p>

Answer 3

<p>A numerical approach to investigating accounts by comparing two related figures.</p>

Question 4

<p>How is Return on Capital Employed (ROCE) defined?</p>

Answer 4

<p>The profit of a business as a percentage of the total amount of money used to generate it.</p>

Question 5

<p>How is Window Dressing defined?</p>

Answer 5

<p>The legal manipulation of accounts by a business to present a financial picture that is to its benefit.</p>

Question 6

<p>What is Ratio Analysis?</p>

Answer 6

<p>Ratio analysis – a method of assessing a firm’s financial situation by comparing two sets of linked data.
<br></br>- Analysts use ratios to compare the relative performance of one company against another, or within a company, of departments against budgets.</p>

Question 7

<p>What are the Stages of Ratio Analysis?</p>

Answer 7

<p>If ratios are to be useful its important to use the right one. The following process allows for this:
<br></br>1 - Identify the reason for the investigation
<br></br>2 - Decide on relevant ratio(s)
<br></br>3 - Gather the information required, then calculate the ratio
<br></br>4 - Interpret the ratio
<br></br>5 - Make the appropriate comparisons
<br></br>6 - Take action based on results
<br></br>7 - Repeat process again</p>

Question 8

<p>How does a Business compare its finding from Ratio Analysis?</p>

Answer 8

<p>Ratios are meaningless on their own, they need to be compared with other results:
<br></br>1 - Inter-firm comparisons – comparisons between companies. A company compares itself against others in order to asses their relative performance. Ideally selecting the competitors with the most in common.
<br></br>2 - Intra-firm comparisons – comparisons within the company. The efficiencies of different divisions or locations can be compared
<br></br>3 - Comparisons to a standard – certain ratios are recognised as efficient within the business community
<br></br>4 - Comparisons over time – comparing quarterly or annual data allows you to assess progress over time.</p>

Question 9

<p>What are Gearing Ratio?</p>

Answer 9

<p>- The Gearing Ratio measures the levels of borrowing within a business ( the relationship between loans on which interest is paid and shareholder's equity on which dividends might be paid) in which . It is important for a business to measure the amount of debt as too much can impact on the ability of the business to service (pay) that debt.
<br></br>- If the company can’t meet the interest and capital repayments, it will impact on the company’s solvency.</p>

Question 10

<p>How do you calculate the Gearing Ratio?</p>

Answer 10

<p>GR = (Non-current Liabilities)/(Capital Employed) x 100
<br></br>
<br></br>Capital Employed = (NCA + CA - CL)</p>

Question 11

<p>What does the Gearing Ratio mean?</p>

Answer 11

<p>- If the gearing ratio is greater than 50%, then the business is said to have a high capital gearing.
<br></br>- If the gearing ratio is less than 25%, then the business is said to have a low capital gearing.
<br></br>- Between 25% and 50% is said to be a normal level of capital gearing.</p>

Question 12

<p>What are the Benefits of High Capital Gearing?</p>

Answer 12

<p>High capital gearing offers several benefits:
<br></br>- There are relatively few shareholders, so easier for existing shareholders to keep control
<br></br>- If interest rates are low, it can be a very cheap source of finance.
<br></br>- In times of high profits, interest payments would likely be lower than dividend expectations of shareholders, allowing the business to retain more profits for investment.</p>

Question 13

<p>What are the Benefits of Low Capital Gearing?</p>

Answer 13

<p>Low capital gearing also has advantages:
<br></br>- With more capital provided through shares, less opportunity for payables (creditors) to force business into liquidation.
<br></br>- Low geared companies avoid large interest repayments in times of high interest rates
<br></br>- The company avoids the pressure of having to repay all the debt at some stage in the future.</p>

Question 14

<p>What is a General Summary for Gearing Ratios?</p>

Answer 14

<p>- Highly profitable businesses prefer high gearing to shareholder funds as a source of finance, as interest payments can be managed from profits, but little shareholders to take those profits as dividends
<br></br>- Lower gearing tends to suit businesses that are less profitable, where the ability to adapt to increased interest payments if rates change is limited.</p>

Question 15

<p>What is Return on Capital Employed?</p>

Answer 15

<p>- Return on capital employed shows the operating profit (before tax) as a percentage of capital employed.
<br></br>- Tax is ignored because it is determined by the government and is therefore outside the control of the company
<br></br>- Interest is excluded because it does not relate to the business's ordinary trading activities
<br></br>- Operating Profit is used as it only covers profits from trading, not exceptional items.
<br></br>- Capital employed is the total equity provided by shareholder funds (share capital and retained profit) plus non-current liabilities (long term loans + debentures)</p>

Question 16

<p>How do you calculate Return on Capital Employed?</p>

Answer 16

<p>ROCE = (OP before tax)/ (NCA + CA - CL) x 100</p>

Question 17

<p>What does Return on Capital Employed ratio mean?</p>

Answer 17

<p>- The ROCE will vary between industries, but the general rule is, the higher the better.
<br></br>- It is effectively measuring the return made from an activity based on the capital being used. You could consider it as an investment appraisal method.
<br></br>- Much like a ARR calculation, you are comparing the return against other potential uses for the capital, the opportunity cost.</p>

Question 18

<p>What are the Limitations of Ratio Analysis?</p>

Answer 18

<p>- The basis for comparison --> Comparison over time, Inter-firm comparisons and Other Differences
<br></br>- The quality of final account
<br></br>- Limitations of the balance sheet
<br></br>- Qualitative information is ignored
<br></br>- Window Dressing</p>

Question 19

<p>Why is the Comparison over Time as a Basis of Comparison a Limitation of Ratio Analysis?</p>

Answer 19

<p>- Care must be taken when comparing ratios from the same company over time
<br></br>- Many companies remain broadly in the same industrial sector overtime, but other can diversify and change very rapidly
<br></br>- Equally, some companies remain the same size over time, Other, grow rapidly or shrink quickly
<br></br>- Such factors can affect the way in which ratios can be used as a measure of performance</p>

Question 20

<p>Why is Inter-Firm Comparisons as a Basis of Comparison a Limitation of Ratio Analysis?</p>

Answer 20

<p>- Caution must also be used when comparing ratios between companies at a point in time
<br></br>- Comparing Ratios between comparing ratios between companies at a point in time
<br></br>- Comparing the ratios of two companies that make broadly the same product is likely to say something about their relative performance
<br></br>- But comparing the ratios of a supermarket chain with those of a cement manufacturer is unlikely to be helpful</p>

Question 21

<p>Why is Other differences as a Basis of Comparisons as a Limitations of Ratio Analysis?</p>

Answer 21

<p>- Even when companies are well matched in their activities and operating circumstances, there may be other difference between them that must be observed e.g. two similar companies may use different accounting techniques, different ends to the financial year etc.</p>

Question 22

<p>Why is The Quality of Final Accounts a Limitations of Ratio Analysis?</p>

Answer 22

<p>- Ratios are based on financial accounts, such as as balance sheets and income statements
<br></br>- Consequently ratio analysis is only useful if the accounts are accurate
<br></br>- One factors that can affect the quality of accounting information is the change in monetary values cause by inflation
<br></br>- Rising prices can distort comparisons made between different time periods e.g. in times, of high inflation there might be no increase in real terms
<br></br>- There is also the possibility that the accounts have been window dressed</p>

Question 23

<p>Why is the Limitations of the Balance a Limitations of Ratio Analysis?</p>

Answer 23

<p>- Because the balance sheet is a 'snapshot of the business at the end of the financial year, it might not be representative of the business's circumstances throughout the whole of the year
<br></br>- For example, a business experiences its peak trading activity in the summer and it has its year end in January when trade is slow, figures for stock and debtors will be unrepresentative</p>

Question 24

<p>Why is the Qualitative Information is Ignored a Limitation of Ratio Analysis?</p>

Answer 24

<p>- Ratios only use quantitative information
<br></br>- However, some important qualitative factors may affect the performance of a business that are ignored by ratio analysis
<br></br>- For example, in the service industry the quality of customer service may be an important performance indicator
<br></br>- However, ratio analysis cannot isolate the impact that good customer service might have on sales
<br></br>- Sales might be higher as a result of good customer service but there might be other factors that have helped to increase sales, such as advertising</p>

Question 25

<p>How is Window Dressing is Limitation of Ratio Analysis?</p>

Answer 25

<p>- Account must represent a 'true and fair record' of the financial affairs of a business.
<br></br>- Legislation and financial reporting standards place limits on the different ways in which a business can present financial information
<br></br>- These limits are designed to prevent fraud and misrepresentation in the compilation and presentation of accounts
<br></br>- However, businesses ca manipulate their accounts legally to present different financial pictures
<br></br>- This is know as window dressing</p>

Question 26

<p>Why might Businesses Window Dress their accounts?</p>

Answer 26

<p>- Managers of companies might want to put as good a financial picture forward as possible for shareholders and potential shareholders . Good financial results will attract praise and perhaps rewards. They might also prevent criticism from shareholders and the financial press
<br></br>- If a business wants to raise new capital from investors, then it will want its financial accounts to look as good as possible
<br></br>- Where a business has experienced severe difficulties during the accounting period, it may decide to take action that will make the financial position look even worse now, bur which will improve figures in the future
<br></br>- Making the financial picture look worse may be way of lowering the amount of tax that is paid
<br></br>- If the owners of a business want to sell it , the better the financial position shown on the accounts the higher the price they are likely to get</p>

Question 27

<p>What are some ways to Window Dress an account?</p>

Answer 27

<p>- a business may manipulate its sales by increasing the level of revenue recorded in the income statement
<br></br>- This will increase profit in that accounting period. It may be able to suppress costs by changing its accounting policies or choosing when to 'write off' unprofitable activities.
<br></br>- It can also 'write off' bad debts revalue property, boost liquidity through the sale and leaseback of assets, and manipulate current assets and current liabilities</p>

Question 28

<p>what are profitability ratios</p>

Answer 28

<ul><li><span>illustrate the profitability ofa business compared to other business</span></li><li><span>They usually focus on profit, capital employed and revenue,</span></li></ul>

Question 29

<p>gross profit margin</p>

Answer 29

<p>gross profit x 100 / revenue</p>

Question 30

<p>profit for the year</p>

Answer 30

<p>net profit before tax x 100 / revenue</p>

Question 31

<p>Why is higher gross margin better?</p>

Answer 31

<ol><li><span>Higher gross margins are preferable tolower ones because it means that more gross profit isbeing made per £1 of sales.</span></li><li><span>The gross profit marginwill vary between different industries. The quicker theturnover of inventory, the lower the gross margin that is needed.</span></li><li><span>For example, a supermarket with a fast inventoryturnover is likely to have a lower gross margin than a car retailer with a much slower inventory turnover. Some supermarkets are therefore very successful with relativelylow gross profit margins because of the regular and fastturnover of inventory.</span></li></ol>

Question 32

<p>how can gross profit margin be used to make decisions</p>

Answer 32

<ol><li><span>Gross profit margins may be used by businesses tohelp make decisions. For example, if gross margins arebelow the industry average, action might be needed. Thebusiness may look for new suppliers of key raw materialsor find new working practices to improve efficiency inproduction.</span></li><li><span>Alternatively, a business may decide to raisethe price of the product — if the market can stand suchan increase.</span></li></ol>

Question 33

<p>why are higher net profit margins preffered</p>

Answer 33

<ol><li><span>The profit forthe year (net profit) margin focuses on the 'bottom line' in business. The bottom line refers to the very last linein the statement of comprehensive income. It shows theprofit that is left after all deductions have been made,i.e. the final amount of profit left over for the owners</span></li></ol>

Question 34

<p>what is meant by liquidity</p>

Answer 34

<ul><li><span>abusiness is able to meet its short-term debts. This meansthat a business must have enough liquid resources to pay its immediate bills</span></li></ul>

Question 35

<p>current ratio</p>

Answer 35

<p>current assets / current liabilities</p>

Question 36

<p>acid test ratio</p>

Answer 36

<p>current assets - inventories / current liabilities</p>

Question 37

<p>interpret current ratio figures</p>

Answer 37

<ol><li><span>A business is said to have enough liquidresources if the current ratio is between 1.5:1 and 2:1.</span></li><li><span>If the current ratio is below 1.5 then the business maynot have enough working capital. Thismightmean that a business is over-borrowing or overtrading (doing more business than can be supported by the resources available).</span></li><li><span><i>However, some businesses, such as retailers, often havevery low current ratios, such as 1:1 or below. This isbecause they hold fast-selling stocks and generate cashfrom sales.</i></span></li><li><span>In contrast, operating above a ratio of 2:1 may suggest that too much money is being used unproductively.</span></li></ol>

Question 38

<p>interpret acid test ratio figures</p>

Answer 38

<ol><li><span><strong></strong>If a business has an acid test ratioof less than 1:1, it means that its current assets minusstocks do not cover its current liabilities. This could indicate a potential problem.</span></li><li><span><i>However, as with the currentratio, there is variation between the typical acid test ratiosof businesses in different industries. Again, retailers withstrong cash flows may operate comfortably with an acidtest ratio of less than 1.</i></span></li></ol>