26 - financial ratios Flashcards
Who is profitability important to
investors when deciding which business to invest in
directors and managers of the business to assess if the business is becoming more or less successful over time. Could cause them to take action if it is decreasing.
What are the 3 profitability ratios and their full forms
ROCE (Return on capital employed)
NPM (Net profit margin)
GPM (Gross profit margin)
2 liquidity ratios
Current ratio
ACID test ratio
What is the current ratio formula
a good range for it
Current assets/Current liabilities
recommended to be in between 1.5 to 2
What happens if current ratio is below 1 or above 2
and 1 drawback of the current ratio
below 1: the business could have real cash flow problems. It would not be able to not pay off its short-term debts from current assets.
above 2: that too much working capital is tied up in unprofitable current assets
drawback:
always assumes that all current assets can be turned into cash quickly. Not always the case (if inventory is hard to sell etc)
What is ACID test ratio formula
good range for it
(Current assets - inventory)/current liabilites
good range: 1 to 1.5
What happens if ACID test ratio is within the range
below the range
Means that the business can pay off its short term debts using its most liquid assets.
if the ACID test ratio is below 1 that shows that the business can’t pay off its short term debts using its most liquid assets and could run into a cashflow problem
Why do managers need the financial statements and ratios
Control and monitor the performance of each product or division of the business.
Managers will be able to identify which parts of the business are performing well or poorly
Compare the business’s profitability and liquidity to other years and other businesses
Why do shareholders need the financial statements
Want to compare the business’s profitability and ratios to other businesses’ profitability and liquidity to decide which is the best investment. Also want to compare to previous years to see if the performance is increasing or decreasing.
Why do creditor’s need a business’s financial statements
Liquidity ratios - need to know the ability of the company to pay back their debts
If there the business faces a liquidity problem then the suppliers may refuse to supply on credit.
Why banks need a business’s financial statements
If the business seems to be at risk of becoming illiquid, it is unlikely that a bank will be willing to lend more.
Why do workers and trade unions need a business’s financial statements
Workers and trade unions will want to assess whether the future of the company is secure or not
Would want to see if the profitability of the company is increasing or not in order to bargain for a raise.
why do Other businesses – especially those in the same industry need the business’s financial statements
The managers of other companies may be considering a bid to take over the company or they may just wish to compare the performance of the business with that of their own.
Limitations of ratio analysis
External users will only have access to accounts and data required by law, and not all the accounts
Ratios are based on past performance and may not indicate how the company will perform in the future
accounting data overtime is affected by inflation and therefore it may be misleading to compare data between years
Different companies may used different accounting methods and valuation methods. These could lead to different ratio results, making comparisons different.
